Can Risk Aversion Explain Stock Price Volatility?

April 10, 2013 5:00am by Guest Author

Can Risk Aversion Explain Stock Price Volatility?
By Stephen F. LeRoy
April 8, 2013

Why are the prices of stocks and other assets so volatile? Efficient capital markets theory implies that stock prices should be much less volatile than actually observed, reflecting an unrealistic assumption that investors are risk neutral. If instead investors are assumed to be risk averse, predicted volatility is higher. However, models that incorporate investor avoidance of risk can explain real-world stock price volatility only under levels of risk aversion that are unrealistically high. Thus, price volatility remains unexplained.

FRBSF Economic Letter April 8, 2013

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