Temporal Risk Aversion and Asset Prices

24 Pages Posted: 19 Mar 2008 Last revised: 9 Aug 2008

See all articles by Skander Van den Heuvel

Skander Van den Heuvel

Board of Governors of the Federal Reserve System

Date Written: July 2008

Abstract

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.

Keywords: Temporal risk aversion, equity premium, risk-free rate puzzle, intertemporal substitution

JEL Classification: G12

Suggested Citation

Van den Heuvel, Skander, Temporal Risk Aversion and Asset Prices (July 2008). EFA 2008 Athens Meetings Paper, AFA 2009 San Francisco Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1099582 or http://dx.doi.org/10.2139/ssrn.1099582

Skander Van den Heuvel (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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