The implications of first-order risk aversion for asset market risk premiums

In an effort to explain simultaneously the excess return predictability observed in equity, bond and foreign exchange markets, we incorporate preferences exhibiting first-order risk aversion into a general equilibrium two-country monetary model. When we calibrate the model to US and Japanese data, we find that first-order risk aversion substantially increases excess return predictability. However, this increased predictability is insufficient to match the data. We conclude that the observed patterns of excess return predictability are unlikely to be explained purely by time-varying risk premiums generated by highly risk averse agents in a complete markets economy.