Explaining Asset Prices with Low Risk Aversion and Low Intertemporal Substitution

Martin M. Andreasen () and Kasper Jørgensen ()
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Martin M. Andreasen: Aarhus University and CREATES, Postal: Aarhus University and CREATES, Department of Economics and Business Economics, Fuglesangs Alle 4, 8210 Aarhus V
Kasper Jørgensen: Aarhus University and CREATES, Postal: Aarhus University and CREATES, Department of Economics and Business Economics, Fuglesangs Alle 4, 8210 Aarhus V

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: This paper extends the class of Epstein-Zin-Weil preferences with a new utility kernel that disentangles uncertainty about the consumption trend (long-run risk) from short-term variation around this trend (cyclical risk). Our estimation results show that these preferences enable the long-run risk model to explain asset prices with a low relative risk aversion (RRA) of 9.8 and a low intertemporal elasticity of substitution (IES) of 0:11. We also show that the proposed preferences allow an otherwise standard New Keynesian model to match the equity premium, the bond premium, and the risk-free rate puzzle with a low IES of 0:07 and a low RRA of 5.

Keywords: Bond premium puzzle; Equity premium puzzle; Long-run risk; Perturbation Approximation; Risk-free rate puzzle. (search for similar items in EconPapers)
JEL-codes: E44 G12 (search for similar items in EconPapers)
Pages: 40
Date: 2016-05-09
New Economics Papers: this item is included in nep-dge, nep-pr~, nep-mac and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2016-16

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