Asset Pricing for the Shortfall Averse

Compare the utility from consuming a certain amount under two circumstances which vary by the levels of past historical consumption. This paper’s premise is that the higher past historical consumption, the lower is the utility from current consumption. The paper and its companion, GHR, extend standard models of utility from dynamic consumption to have this property. Here and in GHR, the behavior of the optimizing consumer/investor takes into consideration the effect of current choices on the utility of future consumption. Assuming a representative agent framework this paper derives the term structure of real interest rates, equity prices and expected real equity returns at all horizons. With relative risk aversion around 4 the implied 3 month real rate and equity premium are .55% and 4.7%, respectively.