Temporal Risk Aversion and Asset Prices

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. 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. Finance Department, Wharton School, 3620 Locust Walk, Philadelphia, PA 19104. Email: [email protected]. I thank Andy Abel, Urban Jermann and the Penn Macro Lunch Group for helpful comments and discussions. Jianfeng Yu provided excellent research assistence. 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.