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Comment on "The Spirit of Capitalism and Stock Market Prices" By G.S. Bakshi and Z. Chen (AER, 1996)

  • Economics


Comment on ‘The Spirit of Capitalism and Stock-Market Prices’ by G.S. Bakshi and Z. Chen (AER, 1996) � by Martin Lettau CentER for Economic Research and Department of Finance, Tilburg University, and CEPR June 2, 1997 �I thank John Campbell for helpful comments. JEL code: G1, G10. ERN �elds: Macroeconomics, Capital Market. 1 2 1 Introduction In a recent paper Bakshi and Chen (BC) (1996) argue that augmenting stan- dard preferences by allowing wealth to directly enter the utility function helps to explain risk premia in capital markets. The motivation for this general- ization comes from the observation that utility might not only be generated by consumption but also by the social status implied by high wealth. The most straightforward way to include this notion into neoclassical economics is to modify the utility function. BC propose various functional forms of preferences which have consumption, wealth and a social-wealth index as arguments. They focus on the implications of these preferences on risk pre- mia by studying the volatility bounds of the intertemporal marginal rate of substitution (IMRS) as suggested by Hansen and Jagannathan (1991). They conclude that their preference speci�cation enter the volatility bounds for more reasonable parameter values than the standard CRRA utility function. In particular, a relative risk aversion coe�cient of about 10 is su�cient com- pared to about 100 for CRRA preferences. This comment argues that this conclusion can be misleading because it does not take into account all restrictions among variables implied by the model. In particular, the authors treat consumption and wealth as indepen- dent variables when they compute the Hansen-Jagannathan bounds of the IMRS. However, one of the implications of the model is that the consumption- wealth ratio is constant and innovations in consumption and wealth are per- fectly correlated. Once these restrictions are used to substitute out wealth

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