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Can We Disentangle Risk Aversion from Intertemporal Substitution in Consumption

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Author Info
Eduardo Schwartz (Anderson School of Management)
Walter Torous (Anderson School of Management)
Abstract

vThe consumption asset pricing framework implies that asset prices may be used to investigate the properties of consumption. An important property of consumption is its elasticity of intertemporal substitution which measures the willingness of individuals to move consumption between time periods in response to changes in interest rates and has important implications for the effectiveness of monetary policy and the behavior of the business cycle. However, consumption asset pricing models typically assume a power utility function in which the elasticity of intertemporal substitution cannot be disentangled from the coefficient of relative risk aversion. While the Epstein-Zin utility function breaks this link, extant empirical tests of this specification have not been able to disentangle these parameter. We argue that this failure arises because data previously used does not properly capture the time dimension needed to accurately estimate the elasticity of intertemporal substitution. We use term structure data, in particular "forward" portfolios which more accurately measure movements across points on the term structure. We find that the Epstein-Zin specification is consistent with out term structure data and we are able to clearly disentangle the elasticity of intertemporal substitution from the coefficient of relative risk aversion.

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Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number 1101.

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Date of creation: 11 Nov 1999
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Handle: RePEc:cdl:anderf:1101

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  1. Hall, Robert E, 1988. "Intertemporal Substitution in Consumption," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 339-57, April. [Downloadable!] (restricted)
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  2. Luttmer, Erzo G J, 1996. "Asset Pricing in Economies with Frictions," Econometrica, Econometric Society, vol. 64(6), pages 1439-67, November. [Downloadable!] (restricted)
  3. 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. [Downloadable!] (restricted)
  4. 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. [Downloadable!] (restricted)
  5. Roma, Antonio & Torous, Walter, 1997. " The Cyclical Behavior of Interest Rates," Journal of Finance, American Finance Association, vol. 52(4), pages 1519-42, September. [Downloadable!] (restricted)
  6. Dunn, Kenneth B. & Singleton, Kenneth J., 1986. "Modeling the term structure of interest rates under non-separable utility and durability of goods," Journal of Financial Economics, Elsevier, vol. 17(1), pages 27-55, September. [Downloadable!] (restricted)
  7. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November. [Downloadable!] (restricted)
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  8. John H. Cochrane & Lars Peter Hansen, 1993. "Asset Pricing Explorations for Macroeconomics," NBER Working Papers 4088, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Blume, Marshall E & Friend, Irwin, 1975. "The Asset Structure of Individual Portfolios and Some Implications for Utility Functions," Journal of Finance, American Finance Association, vol. 30(2), pages 585-603, May. [Downloadable!] (restricted)
  10. Burnside, Craig, 1994. "Hansen-Jagannathan Bounds as Classical Tests of Asset-Pricing Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(1), pages 57-79, January.
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