Substitution, Risk Aversion and Asset Prices: An Expected Utility Approach
AbstractThe standard power utility function is widely used to explain asset prices. It assumes that the coefficient of relative risk aversion is the inverse of the elasticity of substitution. Here I use the Kihlstrom and Mirman (1974) expected utility approach to relax this assumption. I use time consistent preferences that lead to time consistent plans. In our examples, the past does not matter much for current portfolio decisions. The risk aversion parameter can be inferred from experiments and introspections about bets in terms of permanent consumption (wealth). Evidence about the change in the attitude towards bets over the life cycle may also restrict the value of the risk aversion parameter. Monotonic transformations of the standard power utility function do not change the predictions about asset prices by much. Both the elasticity of substitution and risk aversion play a role in determining the equity premium.
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Bibliographic InfoPaper provided by Vanderbilt University Department of Economics in its series Vanderbilt University Department of Economics Working Papers with number 0803.
Date of creation: Jan 2008
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Consumption smoothing; intertemporal elasticity of substitution; risk aversion; asset prices; equity premium;
Find related papers by JEL classification:
- D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
- 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
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-01-26 (All new papers)
- NEP-DGE-2008-01-26 (Dynamic General Equilibrium)
- NEP-UPT-2008-01-26 (Utility Models & Prospect Theory)
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