Abstract - 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 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.

Skander Van den Heuvel
Wharton School, University of Pennsylvania
03.Jun 2008

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