Asset Pricing with Heterogeneous Recursive Preferences

We introduce heterogeneity in agents’ risk aversion into a general equilibrium asset pricing framework with recursive preferences. Agents trade in a stock, whose dividend is the only source of consumption, and in a short-term bond in zero net supply. In equilibrium the less risk averse agents are leveraged in the stock, and their share in the economy’s wealth is positively correlated with the dividend shock. Loosely speaking, ”average risk aversion” declines when dividend growth is strong, which implies lower expected excess returns. At the same time the price-dividend ratio rises. Thus, in line with the data, a high price dividend ratio predicts low future excess returns. Moreover, predictability of excess returns displays the empirically observed pattern of R2 s rising with horizon. We manage to generate R2 s of similar magnitudesas in the data at all horizons.