Substitution, Risk Aversion and Asset Prices:
An Expected Utility Approach
Working Paper No. 08-W03
Benjamin Eden
ABSTRACT [article]
The standard power utility
function is widely used to explain asset prices. It assumes that
the coefficient of relative risk aversion is the inverse of the
elasticity of substitution. Here I use the Kihlstrom and Mirman
(1974) expected utility approach to relax this assumption. I use
time consistent preferences that lead to time consistent plans. In
our examples, the past does not matter much for current portfolio
decisions. The risk aversion parameter can be inferred from
experiments and introspections about bets in terms of permanent
consumption (wealth). Evidence about the change in the attitude
towards bets over the life cycle may also restrict the value of
the risk aversion parameter. Monotonic transformations of the
standard power utility function do not change the predictions
about asset prices by much. Both the elasticity of substitution
and risk aversion play a role in determining the equity premium.
Keywords and Phrases: Consumption smoothing, intertemporal elasticity of
substitution, risk aversion, asset prices, equity premium
JEL Classification Numbers: D11, D81, D91, G12