Temporal risk aversion and asset prices
AbstractAgents with standard, time-separable preferences do not care about the temporal distribution of risk. This is a strong assumption. For example, it seems plausible that a consumer may find persistent shocks to consumption less desirable than uncorrelated fluctuations. Such a consumer is said to exhibit temporal risk aversion. This paper examines the implications of temporal risk aversion for asset prices. The innovation is to work with expected utility preferences that (i) are not time-separable, (ii) exhibit temporal risk aversion, (iii) separate risk aversion from the intertemporal elasticity of substitution, (iv) separate short-run from long-run risk aversion and (v) yield stationary asset pricing implications in the context of an endowment economy. Closed form solutions are derived for the equity premium and the risk free rate. The equity premium depends only on a parameter indexing long-run risk aversion. The risk-free rate instead depends primarily on a separate parameter indexing the desire to smooth consumption over time and the rate of time preference.
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Bibliographic InfoPaper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2008-37.
Date of creation: 2008
Date of revision:
Other versions of this item:
- NEP-ALL-2008-09-05 (All new papers)
- NEP-BEC-2008-09-05 (Business Economics)
- NEP-DGE-2008-09-05 (Dynamic General Equilibrium)
- NEP-MAC-2008-09-05 (Macroeconomics)
- NEP-UPT-2008-09-05 (Utility Models & Prospect Theory)
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