The Role of Risk Aversion and Intertemporal Substitution in Dynamic Consumption-Portfolio Choicewith Recursive Utility
AbstractThe objective of this paper is to understand the implications for consumption and portfolio choice of the separation of an investor’s risk aversion and elasticity of intertemporal substitution that is made possible by recursive utility, in contrast to expected utility, where the two are governed by the same parameter. In particular, we study exactly how risk aversion and elasticity of intertemporal substitution affect optimal dynamic consumption and portfolio decisions. For a three-date, discrete-time model with a stochastic interest rate, we obtain an exact analytic solution for the optimal consumption and portfolio policies. We find that, in general, the consumption and portfolio decisions depend on both risk aversion and the elasticity of intertemporal substitution. Only in the case where the investment opportunity set is constant, is the optimal portfolio weight independent of the elasticity of intertemporal substitution. We also find that the size of risk aversion relative to unity determines the sign of the intertemporal hedging component in the optimal portfolio, while elasticity of intertemporal substitution affects only the magnitude of the hedging component.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5020.
Date of creation: Apr 2005
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- Bhamra, Harjoat S. & Uppal, Raman, 2006. "The role of risk aversion and intertemporal substitution in dynamic consumption-portfolio choice with recursive utility," Journal of Economic Dynamics and Control, Elsevier, vol. 30(6), pages 967-991, June.
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- D91 - Microeconomics - - Intertemporal Choice - - - Intertemporal Household Choice; Life Cycle Models and Saving
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
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