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The role of risk aversion and intertemporal substitution in dynamic consumption-portfolio choice with recursive utility

  • Bhamra, Harjoat S.
  • Uppal, Raman

The 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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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 30 (2006)
Issue (Month): 6 (June)
Pages: 967-991

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Handle: RePEc:eee:dyncon:v:30:y:2006:i:6:p:967-991
Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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  1. Maurice Obstfeld., 1993. "Risk-Taking, Global Diversification, and Growth," Center for International and Development Economics Research (CIDER) Working Papers C93-016, University of California at Berkeley.
  2. David M Kreps & Evan L Porteus, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Levine's Working Paper Archive 625018000000000009, David K. Levine.
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  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.
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  6. Chacko, George & Viceira, Luis M, 2005. "Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets," CEPR Discussion Papers 4913, C.E.P.R. Discussion Papers.
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  9. repec:fth:harver:1421 is not listed on IDEAS
  10. Svensson, Lars E. O., 1989. "Portfolio choice with non-expected utility in continuous time," Economics Letters, Elsevier, vol. 30(4), pages 313-317, October.
  11. 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.
  12. Schroder, Mark & Skiadas, Costis, 2003. "Optimal lifetime consumption-portfolio strategies under trading constraints and generalized recursive preferences," Stochastic Processes and their Applications, Elsevier, vol. 108(2), pages 155-202, December.
  13. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, December.
  14. Schroder, Mark & Skiadas, Costis, 1999. "Optimal Consumption and Portfolio Selection with Stochastic Differential Utility," Journal of Economic Theory, Elsevier, vol. 89(1), pages 68-126, November.
  15. Ma, Chenghu, 1993. "Market Equilibrium with Heterogenous Recursive-Utility-Maximizing Agents," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 3(2), pages 243-66, April.
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