Temporal Risk Aversion and Long Run Risks

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 …nd persistent shocks to consumption less desirable than uncorrelated ‡uctuations. Such a consumer is said to exhibit temporal risk aversion. This paper examines the implications of temporal risk aversion for asset prices, including in the presence of long-run risk. 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 endowment economies. For iid consumption growth, 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. With long-run risk, the model is able to match and explain simultaneously the volatilty of equity returns, the equity premium, risk-free rate, and other key asset pricing facts. Email: [email protected]. This paper draws heavily on a companion paper, “Temporal Risk Aversion and Asset Prices,”by the same author. In addition to the new results in this paper, there is some overlap with the companion paper for ease of presentation. This will be reduced in future versions. I thank Andy Abel, Urban Jermann, Stavros Panageas, Amir Yaron and Stan Zin for helpful comments and discussions. Financial support from the Brandywine Global Investment Management Fellowship from Rodney L. White Center at the Wharton School of the University of Pennsylvania is gratefully appreciated. The views expressed in this paper are my own and do not necessarily re‡ect the views of the Board of Governors or the sta¤ of the Federal Reserve System.