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Asset Pricing with Horizon-Dependent Risk Aversion

Author

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  • Thomas Eisenbach

    (Federal Reserve Bank of New York)

  • Martin Schmalz

    (University of Michigan)

  • Marianne Andries

    (Toulouse School of Economics)

Abstract

We study general equilibrium asset prices in a multi-period endowment economy when agents' risk aversion is allowed to depend on the maturity of the risk. In our pseudo-recursive preference framework, agents are time inconsistent for their intra-temporal decision making, though time consistent for inter-temporal decisions. We find, in the absence of jumps and under log-normal consumption growth, horizon-dependent risk aversion preferences affect the term structure of risk premia if and only if volatility is stochastic. When risk aversion decreases with the horizon (as lab experiments indicate), and the elasticity of intertemporal substitution is greater than one, our model results in a downward slopping (in absolute value) pricing of volatility risk, which, in turns, can explain the recent empirical results on the term structure of risky asset returns. We confirm this prediction using index options data.

Suggested Citation

  • Thomas Eisenbach & Martin Schmalz & Marianne Andries, 2015. "Asset Pricing with Horizon-Dependent Risk Aversion," 2015 Meeting Papers 1069, Society for Economic Dynamics.
  • Handle: RePEc:red:sed015:1069
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    Cited by:

    1. Thomas Conlon & John Cotter & Chenglu Jin, 2019. "Co-skewness across Return Horizons," Working Papers 201910, Geary Institute, University College Dublin.
    2. Roberto Marfè, 2015. "Income Insurance and the Equilibrium Term-Structure of Equity," Carlo Alberto Notebooks 407, Collegio Carlo Alberto.
    3. Epper, Thomas & Fehr-Duda, Helga, 2017. "A Tale of Two Tails: On the Coexistence of Overweighting and Underweighting of Rare Extreme Events," Economics Working Paper Series 1705, University of St. Gallen, School of Economics and Political Science.
    4. Marianne Andries & Thomas M. Eisenbach & Martin C. Schmalz & Yichuan Wang, 2015. "The term structure of the price of variance risk," Staff Reports 736, Federal Reserve Bank of New York.
    5. Baeho Kim & Da‐Hea Kim & Haehean Park, 2020. "Informed options trading on the implied volatility surface: A cross‐sectional approach," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(5), pages 776-803, May.
    6. Dew-Becker, Ian & Giglio, Stefano & Le, Anh & Rodriguez, Marius, 2017. "The price of variance risk," Journal of Financial Economics, Elsevier, vol. 123(2), pages 225-250.

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