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Preferences, Consumption Smoothing, and Risk Premia

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  • Lettau, Martin
  • Uhlig, Harald

Abstract

Risk premia in the consumption capital asset pricing model depend on preferences and dividends. We develop a decomposition which allows for the separate treatment of both components. We show that preferences alone determine the risk-return trade-off measured by the Sharpe-ratio. In general, the risk-return trade-off implied by preferences depends on the elasticity of a preference-based stochastic discount factor for pricing assets with respect to the consumption innovation. Depending on the particular specification of preferences, the absolute value of this elasticity may coincide with the inverse of the elasticity of intertemporal substitution (e.g. for habit formation preferences) or the coefficient of relative risk-aversion (e.g. for Epstein-Zin preferences). We demonstrate that preferences based on a small elasticity of intertemporal substitution, such as habit formation, produce small risk premia once agents are allowed to save. Departing from the complete markets framework, we show that uninsurable risk can only increase the Sharpe-ratio and risk premia if dividends are correlated with individual consumption.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1678.

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Date of creation: Jul 1997
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Handle: RePEc:cpr:ceprdp:1678

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Keywords: Asset Prices; Consumption; Preferences; Risk Aversion; Risk Premia;

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References

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  1. Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1995. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc.
  2. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 01-90, Wharton School Rodney L. White Center for Financial Research.
  3. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  4. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June.
  5. 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.
  6. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1995. "Asset Pricing Lessons for Modeling Business Cycles," NBER Working Papers 5262, National Bureau of Economic Research, Inc.
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  8. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  9. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April.
  10. repec:fth:harver:1421 is not listed on IDEAS
  11. Larry G. Epstein & Stanley E. Zin, 1987. "Substitution, Risk Aversion and the Temporal Behaviour of Consumption and Asset Returns II: An Empirical Analysis," Working Papers 698, Queen's University, Department of Economics.
  12. 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.
  13. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  14. 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.
  15. Gary Hansen, 2010. "Indivisible Labor and the Business Cycle," Levine's Working Paper Archive 233, David K. Levine.
  16. Wouter J. Den Haan, 1996. "Understanding Equilibrium Models with a Small and a Large Number of Agents," NBER Working Papers 5792, National Bureau of Economic Research, Inc.
  17. Alberto Giovannini & Philippe Weil, 1989. "Risk Aversion and Intertemporal Substitution in the Capital Asset Pricing Model," NBER Working Papers 2824, National Bureau of Economic Research, Inc.
  18. Campbell, John, 1994. "Inspecting the Mechanism: An Analytical Approach to the Stochastic Growth Model," Scholarly Articles 3196342, Harvard University Department of Economics.
  19. Campbell, John Y, 1993. "Intertemporal Asset Pricing without Consumption Data," American Economic Review, American Economic Association, vol. 83(3), pages 487-512, June.
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  21. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
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Citations

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Cited by:
  1. Aude Pommeret & Anne Epaulard, 2001. "Agents' Preferences, the Equity Premium, and the Consumption-Saving Trade-Off," IMF Working Papers 01/117, International Monetary Fund.
  2. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
  3. Chiarella Carl & Semmler Willi & Mittnik Stefan & Zhu Peiyuan, 2002. "Stock Market, Interest Rate and Output: A Model and Estimation for US Time Series Data," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 6(1), pages 1-39, April.
  4. Tack Yun & Wooheon Rhee, 2004. "Implications of Quasi-Geometric Discounting on the Observable Sharpe Ratio," Econometric Society 2004 North American Summer Meetings 243, Econometric Society.
  5. Douch, Mohamed, 2004. "Equity Premiums In Small Open Economy," MPRA Paper 14613, University Library of Munich, Germany.
  6. Andreas Hornstein & Harald Uhlig, 2000. "What is the Real Story for Interest Rate Volatility?," German Economic Review, Verein für Socialpolitik, vol. 1(1), pages 43-67, 02.
  7. Pijoan-Mas, Josep, 2006. "Pricing Risk in Economies with Heterogenous Agents and Incomplete Markets," CEPR Discussion Papers 5602, C.E.P.R. Discussion Papers.
  8. Olivier Allais & Loic Cadiou & Stéphane Dees, 2001. "Defining Consumption Behaviour in a Multi-Country Model," Working Papers 2001-02, CEPII research center.
  9. Lettau, M., 1997. "Comment on "The Spirit of Capitalism and Stock Market Prices" By G.S. Bakshi and Z. Chen (AER, 1996)," Discussion Paper 1997-49, Tilburg University, Center for Economic Research.
  10. Cepii & Cepremap, 2001. "MARMOTTE : a Multinational Model," Working Papers 2001-15, CEPII research center.

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