Substitution, Risk Aversion and Asset Prices: An Expected Utility Approach

Benjamin Eden ()

No 803, Vanderbilt University Department of Economics Working Papers from Vanderbilt University Department of Economics

Abstract: 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: Consumption smoothing; intertemporal elasticity of substitution; risk aversion; asset prices; equity premium (search for similar items in EconPapers)
JEL-codes: D11 D81 D91 G12 (search for similar items in EconPapers)
Date: 2008-01
New Economics Papers: this item is included in nep-dge and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:van:wpaper:0803

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