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Preferences, Consumption Smoothing, and Risk Premia

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Author Info
Lettau, Martin
Uhlig, Harald

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

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Find related papers by JEL classification:
E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

References listed on IDEAS
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  1. 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. [Downloadable!] (restricted)
    Other versions:
  2. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April. [Downloadable!] (restricted)
    Other versions:
  3. Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  4. 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. [Downloadable!] (restricted)
  5. Hansen, Gary D., 1985. "Indivisible labor and the business cycle," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 309-327, November. [Downloadable!] (restricted)
  6. Abel, A.B., 1990. "Asset Prices Under Habit Formation And Catching Up With The Joneses," Weiss Center Working Papers 1-90, Wharton School - Weiss Center for International Financial Research.
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  7. Lucas, Deborah J., 1994. "Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 325-341, December. [Downloadable!] (restricted)
  8. 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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  9. Wouter J. Den Haan, 1996. "Understanding Equilibrium Models with a Small and a Large Number of Agents," University of California at San Diego, Economics Working Paper Series 96-34, Department of Economics, UC San Diego. [Downloadable!]
  10. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November. [Downloadable!] (restricted)
  11. John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  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. [Downloadable!] (restricted)
  13. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago. [Downloadable!]
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  14. Campbell, John Y, 1993. "Intertemporal Asset Pricing without Consumption Data," American Economic Review, American Economic Association, vol. 83(3), pages 487-512, June. [Downloadable!] (restricted)
    Other versions:
  15. 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. [Downloadable!] (restricted)
  16. repec:fth:harver:1421 is not listed on IDEAS
  17. 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. [Downloadable!] (restricted)
  18. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
  19. Campbell, John Y., 1994. "Inspecting the mechanism: An analytical approach to the stochastic growth model," Journal of Monetary Economics, Elsevier, vol. 33(3), pages 463-506, June. [Downloadable!] (restricted)
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  20. 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.
  21. John H. Cochrane & Lars Peter Hansen, 1992. "Asset Pricing Explorations for Macroeconomics," NBER Chapters, in: NBER Macroeconomics Annual 1992, Volume 7, pages 115-182 National Bureau of Economic Research, Inc. [Downloadable!]
    Other versions:
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Cepii & Cepremap, 2001. "MARMOTTE: A Multinational Model," Working Papers 2001-15, CEPII research center. [Downloadable!]
  2. Josep Pijoan-Mas, 2002. "Pricing Risk in Economies with Heterogenous Agents and Incomplete Markets," Centro de Alti­simos Estudios Ri­os Pe©rez(CAERP) 3, Centro de Altisimos Estudios Rios Perez (CAERP). [Downloadable!]
    Other versions:
  3. Lettau, M., 1997. "Comment on 'the spirit of capitalism and stock-market-prices' by G.S. Bakshi and Z. Chen (AER, 1996)," Discussion Paper 49, Tilburg University, Center for Economic Research. [Downloadable!]
  4. Douch, Mohamed, 2004. "Equity Premiums In a Small Open Economy," MPRA Paper 876, University Library of Munich, Germany. [Downloadable!]
    Other versions:
  5. Michele Boldrin & Lawrence J. Christiano & 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. [Downloadable!] (restricted)
    Other versions:
  6. 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. [Downloadable!]
  7. Olivier Allais & Loic Cadiou & Stephane Dees, 2001. "Defining Consumption Behavior in a Multi-Country Model," Working Papers 2001-02, CEPII research center. [Downloadable!]
  8. Aude Pommeret & Anne Epaulard, 2001. "Agents' Preferences, the Equity Premium, and the Consumption-Saving Trade-Off: An Application to French Data," IMF Working Papers 01/117, International Monetary Fund. [Downloadable!]
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