Consumption-portfolio choice and asset pricing with preferences for social status

• Applicant: Professor Dr. Holger Kraft
• Subject Area: Accounting and Finance
• Term: from 2019 to 2023
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 420492791

Benchmarking own achievements is a process that is inherent in today’s society. For instance, adults use income to benchmark themselves against colleagues or neighbors. Following these ideas, our project studies the effects of social interaction on financial decisions of individuals and asset prices. The utility specification proposed in our project captures some essential aspects of our lives, namely getting ahead of our peers or feelings of envy. In particular, these preferences for social status capture the empirical evidence that agents benchmark their consumption and/or wealth against their peers. This leads to involved interlinked decision problems that can be formally described as stochastic differential games. Our project contributes to two fields of Finance, namely, consumption-portfolio choice and equilibrium asset pricing. In the first case, we analyze how financial decisions of agents change when they are benchmarked against peers. Our formulation gives rise to additional hedging motives that are not present in standard models. A potential application is the effect on the decisions of fund managers. The performance of actively managed funds can be evaluated in two dimensions: First, one can measure the relative performance with respect to a passive benchmark such as the S&P 500 that is exogenously given. Second, one can compare the fund performance with the performance of funds in the same category. The latter has become increasingly important since the mid of the 90s when, among others, Morningstar Inc. introduced peer-group based fund rankings. We would like to analyze in which direction the decisions of fund managers are tilted if they are benchmarked against their peers. In particular, it is crucial to understand how peer-group based rankings influence the portfolio strategies in a financial crisis. This is because systematic distortions of the demands for certain assets can severely amplify the effects of a crisis.In the case of equilibrium asset pricing, we extend our analysis of social preferences into another direction: Instead of considering the effect of contemporaneous benchmarking on the asset demands of individuals, we study a general equilibrium setting where market clearing conditions are imposed. In such a setting, we can solve for the equilibrium stock return, stock volatility, risk-free rate, and market price of risk. We can thus address the question of whether preferences for social status can contribute to explaining various asset pricing phenomena in an economy that are at the heart of asset pricing such as the famous equity premium puzzle or the excess volatility puzzle. Furthermore, we can derive the dynamics of an economy-wide benchmark that is consistent with a general equilibrium setting. Finally, our model generates endogenous predictability of asset pricing moments that, by the flexibility of the model, can be calibrated to predictability patterns as observed in the data.

• DFG Programme: Research Grants