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The Role of Risk Aversion and Intertemporal Substitution in Dynamic Consumption-Portfolio Choicewith 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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5020.

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Date of creation: Apr 2005
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Handle: RePEc:cpr:ceprdp:5020
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  1. 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.
  2. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, vol. 46(1), pages 185-200, January.
  3. Maurice Obstfeld, 1992. "Risk-Taking, Global Diversification, and Growth," NBER Working Papers 4093, National Bureau of Economic Research, Inc.
  4. 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.
  5. Bernard Dumas & Raman Uppal, 1999. "Global Diversification, Growth and Welfare with Imperfectly Integrated Markets for Goods," NBER Working Papers 6994, National Bureau of Economic Research, Inc.
  6. John Y. Campbell & Luis M. Viceira, 1998. "Who Should Buy Long-Term Bonds?," NBER Working Papers 6801, National Bureau of Economic Research, Inc.
  7. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  8. repec:fth:harver:1421 is not listed on IDEAS
  9. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, March.
  10. George Chacko & Luis M. Viceira, 1999. "Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets," NBER Working Papers 7377, National Bureau of Economic Research, Inc.
  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. Weil, Philippe, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 29-42, February.
  13. Ma, Chenghu, 1993. "Market Equilibrium with Heterogenous Recursive-Utility-Maximizing Agents," Economic Theory, Springer, vol. 3(2), pages 243-66, April.
  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. Svensson, L.E.O., 1988. "Portfolio Choice With Non-Expected Utility In Continuous Time," Papers 423, Stockholm - International Economic Studies.
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