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Substitution, Risk Aversion and Asset Prices: An Expected Utility Approach

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  • Benjamin Eden

    ()
    (Department of Economics, Vanderbilt University)

Abstract

The 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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File URL: http://www.accessecon.com/pubs/VUECON/vu08-w03.pdf
File Function: First version, 2008
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Bibliographic Info

Paper provided by Vanderbilt University Department of Economics in its series Vanderbilt University Department of Economics Working Papers with number 0803.

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Date of creation: Jan 2008
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Handle: RePEc:van:wpaper:0803

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Web page: http://www.vanderbilt.edu/econ/wparchive/index.html

Related research

Keywords: Consumption smoothing; intertemporal elasticity of substitution; risk aversion; asset prices; equity premium;

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References

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  1. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 98(3), pages 519-43, June.
  2. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, Econometric Society, vol. 46(6), pages 1429-45, November.
  3. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  4. Peleg, Bezalel & Yaari, Menahem E, 1973. "On the Existence of a Consistent Course of Action when Tastes are Changing," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 40(3), pages 391-401, July.
  5. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  6. Eden, Benjamin, 1977. "The role of insurance and gambling in allocating risk over time," Journal of Economic Theory, Elsevier, Elsevier, vol. 16(2), pages 228-246, December.
  7. Eden, Benjamin, 1979. "An Expected Utility Function for the Insurance Buying Gambler," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 46(4), pages 741-42, October.
  8. 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, Econometric Society, vol. 57(4), pages 937-69, July.
  9. David M Kreps & Evan L Porteus, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Levine's Working Paper Archive 625018000000000009, David K. Levine.
  10. Kihlstrom, Richard E. & Mirman, Leonard J., 1974. "Risk aversion with many commodities," Journal of Economic Theory, Elsevier, Elsevier, vol. 8(3), pages 361-388, July.
  11. Beaudry, Paul & van Wincoop, Eric, 1996. "The Intertemporal Elasticity of Substitution: An Exploration Using a US Panel of State Data," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 63(251), pages 495-512, August.
  12. Robert E. Hall, 1981. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
  13. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 99(2), pages 263-86, April.
  14. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 145-161, March.
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Cited by:
  1. Antoine Bommier & Fran├žois Le Grand, 2012. "Too Risk Averse to Purchase Insurance? A Theoretical Glance at the Annuity Puzzle," CER-ETH Economics working paper series, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich 12/157, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich.
  2. Antoine Bommier & Fran├žois Grand, 2014. "Too risk averse to purchase insurance?," Journal of Risk and Uncertainty, Springer, Springer, vol. 48(2), pages 135-166, April.

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