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Preferences, Consumption Smoothing and Risk Premia
Lettau,M. Uhlig,H.F.H.V.S.
Lettau,M.
Uhlig,H.F.H.V.S.
Abstract
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.
Description
Pagination: 35
Date
1997
Journal Title
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Publisher
Macroeconomics
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60.pdf
Adobe PDF, 474.17 KB
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Keywords
risk premium, consumption, capital asset pricing, preferences, dividend, E21 - Consumption ; Saving ; Wealth, E44 - Financial Markets and the Macroeconomy, G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates
Citation
Lettau, M & Uhlig, H F H V S 1997 'Preferences, Consumption Smoothing and Risk Premia' CentER Discussion Paper, vol. 1997-60, Macroeconomics, Tilburg.