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The independence axiom and asset returns

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  • Epstein, Larry G.
  • Zin, Stanley E.

Abstract

This paper integrates models of atemporal risk preference that relax the independence axiom into a recursive intertemporal asset-pricing framework. The resulting models are amenable to empirical analysis using market data and standard Euler equation methods. We are thereby able to provide the first non-laboratory-based evidence regarding the usefulness of several new theories of risk preference for addressing standard problems in dynamic economics. Using both stock and bond returns data, we find that a model incorporating risk preferences that exhibit firstorder risk aversion accounts for significantly more of the mean and autocorrelation properties of the data than models that exhibit only second-order risk aversion. Unlike the latter class of models which require parameter estimates that are outside of the admissible parameter space, e.g., negative rates of time preference, the model with first-order risk aversion generates point estimates that are economically meaningful. We also examine the relationship between first-order risk aversion and models that employ exogenous stochastic switching processes for consumption growth.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Empirical Finance.

Volume (Year): 8 (2001)
Issue (Month): 5 (December)
Pages: 537-572

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Handle: RePEc:eee:empfin:v:8:y:2001:i:5:p:537-572

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Web page: http://www.elsevier.com/locate/jempfin

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  1. Donald W.K. Andrews, 1989. "Asymptotics for Semiparametric Econometric Models: III. Testing and Examples," Cowles Foundation Discussion Papers 910, Cowles Foundation for Research in Economics, Yale University.
  2. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  3. Pakes, Ariel & Pollard, David, 1989. "Simulation and the Asymptotics of Optimization Estimators," Econometrica, Econometric Society, vol. 57(5), pages 1027-57, September.
  4. Backus, David K. & Gregory, Allan W. & Zin, Stanley E., 1989. "Risk premiums in the term structure : Evidence from artificial economies," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 371-399, November.
  5. Chew, Soo Hong, 1983. "A Generalization of the Quasilinear Mean with Applications to the Measurement of Income Inequality and Decision Theory Resolving the Allais Paradox," Econometrica, Econometric Society, vol. 51(4), pages 1065-92, July.
  6. Shmuel Kandel & Robert F. Stambaugh, 1991. "Asset Returns and Intertemporal Preferences," NBER Working Papers 3633, National Bureau of Economic Research, Inc.
  7. Kandel, S. & Stambaugh, R.F., 1990. "Asset Returns, Investment Horizons, And Intertemporal Preferences," Weiss Center Working Papers 7-90, Wharton School - Weiss Center for International Financial Research.
  8. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, vol. 46(1), pages 185-200, January.
  9. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics 29, Federal Reserve Bank of Minneapolis.
  10. Shmuel Kandel & Robert F. Stambaugh, . "Asset Returns, Investment Horizons, and Intertemporal Preferences (Reprint 009)," Rodney L. White Center for Financial Research Working Papers 7-90, Wharton School Rodney L. White Center for Financial Research.
  11. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
  12. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
  13. Yaari, Menahem E, 1987. "The Dual Theory of Choice under Risk," Econometrica, Econometric Society, vol. 55(1), pages 95-115, January.
  14. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
  15. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  16. Gallant, A. Ronald & Hansen, Lars Peter & Tauchen, George, 1990. "Using conditional moments of asset payoffs to infer the volatility of intertemporal marginal rates of substitution," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 141-179.
  17. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  18. Camerer, Colin F, 1989. " An Experimental Test of Several Generalized Utility Theories," Journal of Risk and Uncertainty, Springer, vol. 2(1), pages 61-104, April.
  19. Fishburn, Peter C., 1983. "Transitive measurable utility," Journal of Economic Theory, Elsevier, vol. 31(2), pages 293-317, December.
  20. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September.
  21. Conlisk, John, 1989. "Three Variants on the Allais Example," American Economic Review, American Economic Association, vol. 79(3), pages 392-407, June.
  22. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-86, April.
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