Surplus Utility and Intertemporal Asset Pricing

Abstract

I develop a lifecycle asset pricing model with reference-dependent preferences in which agents derive intertemporal gain–loss utility from consumption relative to a forward-looking reference point. Unlike prior applications of such preferences that effectively rely on habit-like, backward-looking reference formation, my model adopts a forward-looking, expectation-based reference point. I introduce a surplus utility ratio that captures deviations of realized consumption utility from reference utility and derive the stochastic discount factor in closed form. The resulting pricing kernel incorporates three sources of risk: consumption-growth risk, surplus-utility risk, and loss-aversion risk. I show analytically how these components contribute to the equity premium and characterize their interactions under alternative specifications of the gain–loss function. The model is shown to generate, in steady states, a theoretical equity premium consistent with the observed magnitude in the data while maintaining standard levels of both risk aversion and loss aversion. The model also generates non-monotonic lifecycle consumption profiles and provides a basis for revisiting the permanent income hypothesis when reference points are formed through forward-looking expectations.