Copyright © 2010 Günter Franke and Erik Lüders. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

Abstract

This paper presents a simple rational expectations model of intertemporal asset pricing relating instability of stock return characteristics to heterogeneity in investor preferences. Heterogeneity is likely to generate declining aggregate relative risk aversion. This leads to variability in expected asset returns, volatility, and autocorrelation. The stronger this variability is, the more heterogeneous preferences are, implying more instability of financial markets. Stock market crashes may be observed if relative risk aversion differs strongly across investors.