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Temporal risk aversion and asset prices


  • Skander J. van den Heuvel


Agents with standard, time-separable preferences do not care about the temporal distribution of risk. This is a strong assumption. For example, it seems plausible that a consumer may find persistent shocks to consumption less desirable than uncorrelated fluctuations. Such a consumer is said to exhibit temporal risk aversion. This paper examines the implications of temporal risk aversion for asset prices. The innovation is to work with expected utility preferences that (i) are not time-separable, (ii) exhibit temporal risk aversion, (iii) separate risk aversion from the intertemporal elasticity of substitution, (iv) separate short-run from long-run risk aversion and (v) yield stationary asset pricing implications in the context of an endowment economy. Closed form solutions are derived for the equity premium and the risk free rate. The equity premium depends only on a parameter indexing long-run risk aversion. The risk-free rate instead depends primarily on a separate parameter indexing the desire to smooth consumption over time and the rate of time preference.

Suggested Citation

  • Skander J. van den Heuvel, 2008. "Temporal risk aversion and asset prices," Finance and Economics Discussion Series 2008-37, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2008-37

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    References listed on IDEAS

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    Cited by:

    1. Kihlstrom, Richard, 2009. "Risk aversion and the elasticity of substitution in general dynamic portfolio theory: Consistent planning by forward looking, expected utility maximizing investors," Journal of Mathematical Economics, Elsevier, vol. 45(9-10), pages 634-663, September.
    2. Stanislav Khrapov, 2012. "Risk Premia: Short and Long-term," Working Papers w0169, Center for Economic and Financial Research (CEFIR).
    3. Antoine Bommier, Francois Le Grand, "undated". "Too Risk Averse to Purchase Insurance? A Theoretical Glance at the Annuity Puzzle," Working Papers ETH-RC-12-002, ETH Zurich, Chair of Systems Design.

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    Financial risk management ; Asset pricing;

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