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Evidence for countercyclical risk aversion: an experiment with financial professionals


Cohn, Alain; Engelmann, Jan; Fehr, Ernst; Maréchal, Michel (2015). Evidence for countercyclical risk aversion: an experiment with financial professionals. American Economic Review, 105(2):860-885.

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:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Economics
Dewey Decimal Classification:330 Economics
Date:1 February 2015
Deposited On:16 Feb 2015 08:18
Last Modified:08 Dec 2017 06:54
Publisher:American Economic Association
ISSN:0002-8282
Free access at:Publisher DOI. An embargo period may apply.
Publisher DOI:https://doi.org/10.1257/aer.20131314
Related URLs:http://www.econ.uzh.ch/faculty/fehr/publications/AERcountercyclical.pdf
http://dx.doi.org/10.5167/uzh-80915

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