Three essays on investor preferences

Essay one explores a common assumption of classical asset pricing models. Representative agent models based on the time separable utility function have relied on the assumption that the agent's elasticity of intertemporal substitution is the inverse of risk aversion. We use S&P 500 options and returns to estimate a time series of risk aversion and elasticity of intertemporal substitution (EIS) parameters. We then show that risk aversion and EIS are related to the risk free rate, the market premium and the volatility of the market in ways predicted by theory.; Essay two illustrates the significant difference between risk preferences of individual investors and aggregate preferences toward risk in the economy. We prove that an economy consisting of individual agents who exhibit risk seeking behavior, with identical initial endowments, and facing a budget constraint aggregate to a risk neutral economy. When there is a continuum of wealth endowments, the economy is risk averse in the aggregate. Thus, an economy consisting of risk seeking agents can lead to an aggregate economy that is risk averse. We prove that the converse is also true. An economy demanding a risk premium can be formed from individuals who do not demand such compensation.; Essay three investigates the affects of time varying risk aversion and time varying EIS on the cross section of returns. Theory indicates that the aggregate market will hold the market portfolio and a risk free asset in accordance with the market's level of risk preferences. However, practitioners tell their clients to readjust their risky holdings throughout from risky securities to less risky securities as they grow older. Contrary to asset pricing theory, we find that the market demands less risky securities when the market is more risk averse and riskier securities when the market is less risk averse.