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Substitution and Risk Aversion: Is Risk Aversion Important for Understanding Asset Prices?

  • Benjamin Eden

    ()

    (Department of Economics, Vanderbilt University)

This paper uses a recursive time-non-separable expected utility function to separate between the intertemporal elasticity of substitution (IES) and a measure of relative risk aversion to bets in terms of money (RAM). Risk premium does not require risk aversion. Changes in IES have large effects on asset prices but changes in risk aversion have only a small effect on asset prices. Assuming IES = 1 and allowing a wide range for the RAM coefficient (say between 0 and 10) is consistent with the cross-countries observation made by Lucas (2003) and the net of taxes and net of frictions rates of return estimated by McGrattan and Prescott (2003).

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File URL: http://www.accessecon.com/pubs/VUECON/vu04-w22.pdf
File Function: First version, 2004
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Paper provided by Vanderbilt University Department of Economics in its series Vanderbilt University Department of Economics Working Papers with number 0422.

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Date of creation: Nov 2004
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Handle: RePEc:van:wpaper:0422
Contact details of provider: Web page: http://www.vanderbilt.edu/econ/wparchive/index.html

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  1. Eden, Benjamin, 1977. "The role of insurance and gambling in allocating risk over time," Journal of Economic Theory, Elsevier, vol. 16(2), pages 228-246, December.
  2. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income and Interest Rates: Reinterpreting the Time Series Evidence," NBER Chapters, in: NBER Macroeconomics Annual 1989, Volume 4, pages 185-246 National Bureau of Economic Research, Inc.
  3. Angus Deaton & Christina Paxson, 1993. "Intertemporal Choice and Inequality," NBER Working Papers 4328, National Bureau of Economic Research, Inc.
  4. Tjalling C. Koopmans, 1959. "Stationary Ordinal Utility and Impatience," Cowles Foundation Discussion Papers 81, Cowles Foundation for Research in Economics, Yale University.
  5. Ellen R. McGrattan & Edward C. Prescott, 2003. "Average Debt and Equity Returns: Puzzling?," American Economic Review, American Economic Association, vol. 93(2), pages 392-397, May.
  6. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  7. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  8. David Backus & Bryan Routledge & Stanley Zin, 2004. "Exotic Preferences for Macroeconomists," Working Papers 04-20, New York University, Leonard N. Stern School of Business, Department of Economics.
  9. Weil, Philippe, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 29-42, February.
  10. Gadi Barlevy, 2005. "The cost of business cycles and the benefits of stabilization," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 32-49.
  11. Levhari, David & Srinivasan, T N, 1969. "Optimal Savings under Uncertainty," Review of Economic Studies, Wiley Blackwell, vol. 36(106), pages 153-63, April.
  12. 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.
  13. Robert E. Hall, 1981. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
  14. Christian Gollier, 2004. "The Economics of Risk and Time," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262572249, June.
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