Risk aversion, risk premia, and the labor margin with generalized recursive preferences (original) (raw)

Risk Aversion and the Labor Margin in Dynamic Equilibrium Models

2012

The household's labor margin has a substantial effect on risk aversion, and hence asset prices, in dynamic equilibrium models even when utility is additively separable between consumption and labor. This paper derives simple, closed-form expressions for risk aversion that take into account the household's labor margin. Ignoring this margin can dramatically overstate the household's true aversion to risk. Risk premia on assets priced with the stochastic discount factor increase essentially linearly with risk aversion, so measuring risk aversion correctly is crucial for asset pricing in the model.

Risk Aversion, the Labor Margin, and Asset Pricing in DSGE Models

Federal Reserve Bank of San Francisco, Working Paper Series

In dynamic stochastic general equilibrium (DSGE) models, the household's labor margin as well as consumption margin affects Arrow-Pratt risk aversion. This paper derives simple, closed-form expressions for risk aversion that take into account the household's labor margin. Ignoring the labor margin can lead to wildly inaccurate measures of the household's true attitudes toward risk. We show that risk premia on assets computed using the stochastic discount factor are proportional to Arrow-Pratt risk aversion, so that measuring risk aversion correctly is crucial for understanding asset prices. Closed-form expressions for risk aversion in DSGE models with generalized recursive preferences and internal and external habits are also derived.

Implications of Labor Market Frictions for Risk Aversion and Risk Premia

A flexible labor margin allows households to absorb shocks to asset values with changes in hours worked as well as changes in consumption. This ability to absorb shocks along both margins can greatly alter the household's attitudes toward risk, as shown by Swanson (2012a). The present paper analyzes how those results are affected by labor market frictions and shows that: 1) risk aversion is higher in recessions, 2) risk aversion is higher in more frictional labor markets, and 3) risk aversion is higher for households that are less employable. Quantitatively, labor market flow rates in the U.S. and other OECD countries are large relative to the discount rate, implying that the cost of labor market frictions is small because frictions only delay adjustment. Thus, the frictionless formulas in Swanson (2012a,b) appear to be very good approximations in frictional labor markets as well.

Preferences, consumption smoothing, and risk premia

1997

Risk premia in the consumption capital asset pricing model depend on preferences and dividend. We develop a decomposition which allows a separate treatment of both components. We show that preferences alone determine the risk-return tradeoff measured by the Sharpe-ratio. In general, the risk-return trade-off implied by preferences depends on the elasticity of a preference-based stochastic discount factor for pricing assets with respect to the consumption innovation. Depending on the particular specification of preferences, the absolute value of this elasticity can coincide to the inverse of the elasticity of intertemporal substitution (e.g. for habit formation preferences) or the coefficient of relative risk-aversion (e.g. for Epstein-Zin preferences). We demonstrate that preferences based on a small elasticity of intertemporal substitution, such as habit formation, produce small risk premia once agents are allowed to save. Departing from the complete markets framework, we show that uninsurable risk can only increase the Sharpe-ratio and risk premia if dividends are correlated with individual consumption.

The Term Structure of Risk Premia with Heterogeneous Recursive Preferences and Beliefs

SSRN Electronic Journal, 2017

I investigate the effect of preference and belief heterogeneity on the term structure of risk premia in a continuous-time time economy with Epstein-Zin-Weil preferences. The slope of the term structure of equity risk premia is driven by heterogeneity in the agents' own prices of risk and the sensitivity of the equity market valuation to the changes in economic conditions. As a result, the slope can switch its sign in response to a significant shock to the aggregate consumption. Significant negative shocks shift the consumption and wealth toward the more "pessimistic" agent i.e. the agent with a higher risk aversion or more pessimistic beliefs. As a result, the equity market valuation changes from being pro-cyclical to counter-cyclical, which inverts the term structure. Thus, the model can generate a switch in the sign of the slope of the term structure of the dividend strip risk premia after the 2008-2009 global financial crisis, a result consistent with recent empirical studies and my own calibration based on a proprietary dataset of dividend swap prices.

Substitution, Risk Aversion and Asset Prices: An Expected Utility Approach

The standard power utility function is widely used to explain asset prices. It assumes that the coefficient of relative risk aversion is the inverse of the elasticity of substitution. Here I use the Kihlstrom and Mirman (1974) expected utility approach to relax this assumption. I use time consistent preferences that lead to time consistent plans. In our examples, the past does not matter much for current portfolio decisions. The risk aversion parameter can be inferred from experiments and introspections about bets in terms of permanent consumption (wealth). Evidence about the change in the attitude towards bets over the life cycle may also restrict the value of the risk aversion parameter. Monotonic transformations of the standard power utility function do not change the predictions about asset prices by much. Both the elasticity of substitution and risk aversion play a role in determining the equity premium.

1SUBSTITUTION and Risk Aversion: Is Risk Aversion Important for Understanding Asset PRICES?1

2005

The log utility function is widely used to explain asset prices. It assumes that both the elasticity of substitution and relative risk aversion are equal to one. Here I show that much of the same predictions about asset prices can be derived from a time-non-separable expected utility function that assumes an elasticity of substitution close to unity but does not impose restrictions on risk aversion to bets in terms of money. 1 I would like to thank Jeff Campbell and Greg Huffman for useful comments on an earlier draft.

Consumption Commitments and Risk Preferences

Many households devote a large fraction of their budgets to "consumption commitments" -goods that involve transaction costs and are infrequently adjusted. This paper characterizes risk preferences in an expected utility model with commitments. We show that commitments a¤ect risk preferences in two ways: (1) they amplify risk aversion with respect to moderate-stake shocks and (2) they create a motive to take large-payo¤ gambles. The model thus helps resolve two basic puzzles in expected utility theory: the discrepancy between moderate-stake and large-stake risk aversion and lottery playing by insurance buyers. We discuss applications of the model such as the optimal design of social insurance and tax policies, added worker e¤ects in labor supply, and portfolio choice. Using event studies of unemployment shocks, we document evidence consistent with the consumption adjustment patterns implied by the model. two anonymous referees, and numerous seminar participants for helpful comments. James Sly provided outstanding research assistance. We are grateful for …nancial support from National Science Foundation grant SES 0522073.

Consumption-Based Asset Pricing with Recursive Utility

2017

In this paper it has been attempted to investigate the capability of the consumption-based capital asset pricing model (CCAPM), using the general method of moment (GMM), with regard to the Epstien-zin recursive preferences model for Iran's capital market. Generally speaking, recursive utility permits disentangling of the two psychologically separate concepts of risk aversion and elasticity of intertemporal substitution which are constrained to be equal to the inverse of each other for the traditional time-additive utility functions. Rather than using the stock market as a proxy for wealth, we constructed a more comprehensive return which is the weighted average of stock index return, labor wage growth (as a proxy for human capital return), housing return and deposit return. The empirical results demonstrate that the signs of the coefficient of the relative risk aversion and the intertemporal elasticity of substitution are the same, which means that investors have homogeneous at...

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

2004

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