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The independence axiom and asset returns

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  • Epstein, Larry G.
  • Zin, Stanley E.

Abstract

This paper integrates models of atemporal risk preference that relax the independence axiom into a recursive intertemporal asset-pricing framework. The resulting models are amenable to empirical analysis using market data and standard Euler equation methods. We are thereby able to provide the first non-laboratory-based evidence regarding the usefulness of several new theories of risk preference for addressing standard problems in dynamic economics. Using both stock and bond returns data, we find that a model incorporating risk preferences that exhibit firstorder risk aversion accounts for significantly more of the mean and autocorrelation properties of the data than models that exhibit only second-order risk aversion. Unlike the latter class of models which require parameter estimates that are outside of the admissible parameter space, e.g., negative rates of time preference, the model with first-order risk aversion generates point estimates that are economically meaningful. We also examine the relationship between first-order risk aversion and models that employ exogenous stochastic switching processes for consumption growth.
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Suggested Citation

  • Epstein, Larry G. & Zin, Stanley E., 2001. "The independence axiom and asset returns," Journal of Empirical Finance, Elsevier, vol. 8(5), pages 537-572, December.
  • Handle: RePEc:eee:empfin:v:8:y:2001:i:5:p:537-572
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