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Evidence for countercyclical risk aversion: an experiment with financial professionals


Cohn, Alain; Engelmann, Jan; Fehr, Ernst; Maréchal, Michel (2014). Evidence for countercyclical risk aversion: an experiment with financial professionals. UBS Center Working Paper Series 4, University of Zurich : UBS International Center of Economics in Society.

Abstract

A key ingredient of many popular asset pricing models is that investors exhibit countercyclical risk aversion, which helps explain major economic puzzles such as the strong and systematic variation in risk premiums over time and the high volatility of asset prices. There is, however, surprisingly little evidence for this assumption because it is difficult to control for the host of factors that change simultaneously during financial booms and busts. We circumvent these control problems by priming financial professionals with either a boom or a bust scenario and by subsequently measuring their risk aversion in two experimental investment tasks with real monetary stakes. Subjects who were primed with a financial bust were substantially more risk averse than those who were primed with a boom. Subjects were also more fearful in the bust than in the boom condition, and their fear is negatively related to investments in the risky asset, suggesting that fear may play an important role in countercyclical risk aversion. The mechanism described in this paper is relevant for theory and has important implications, as it provides the basis for a self-reinforcing process that amplifies market dynamics.

Abstract

A key ingredient of many popular asset pricing models is that investors exhibit countercyclical risk aversion, which helps explain major economic puzzles such as the strong and systematic variation in risk premiums over time and the high volatility of asset prices. There is, however, surprisingly little evidence for this assumption because it is difficult to control for the host of factors that change simultaneously during financial booms and busts. We circumvent these control problems by priming financial professionals with either a boom or a bust scenario and by subsequently measuring their risk aversion in two experimental investment tasks with real monetary stakes. Subjects who were primed with a financial bust were substantially more risk averse than those who were primed with a boom. Subjects were also more fearful in the bust than in the boom condition, and their fear is negatively related to investments in the risky asset, suggesting that fear may play an important role in countercyclical risk aversion. The mechanism described in this paper is relevant for theory and has important implications, as it provides the basis for a self-reinforcing process that amplifies market dynamics.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > UBS International Center of Economics in Society
03 Faculty of Economics > Department of Economics
Working Paper Series > UBS Center Working Paper Series
Dewey Decimal Classification:330 Economics
JEL Classification:G02, C91
Uncontrolled Keywords:Countercyclical risk aversion, experiment, financial professionals
Language:English
Date:August 2014
Deposited On:11 Sep 2013 15:56
Last Modified:14 Aug 2017 14:36
Series Name:UBS Center Working Paper Series
Number of Pages:29
ISSN:2296-2751
Additional Information:Revised version
Official URL:http://www.ubscenter.uzh.ch/assets/workingpapers/WP4_Evidence_for_Countercyclical_Risk_Aversion.pdf
Related URLs:http://www.ubscenter.uzh.ch/en/publications/workingpapers

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