Substitution and Risk Aversion: Is
Risk Aversion Important
for Understanding Asset Prices?
Working Paper No. 04-W22
Benjamin Eden
ABSTRACT [article]
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 prices. Assuming IES = 1 and allowing a wide range for the
RAM coefficient (say between 0 and 10) is consistent with the
cross-countries observation made by Lucas (2003) and the net of taxes and
net of frictions rates of return estimated by McGrattan and Prescott (2003).
Keywords and Phrases: Asset pricing, intertemporal elasticity of substitution, risk
aversion
JEL Classification Number: G12