Preferences, Consumption Smoothing, and Risk Premia

Martin Lettau and Harald Uhlig ()

No 1678, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Risk premia in the consumption capital asset pricing model depend on preferences and dividends. We develop a decomposition which allows for the separate treatment of both components. We show that preferences alone determine the risk-return trade-off 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 may coincide with 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.

Keywords: Asset Prices; Consumption; Preferences; Risk Aversion; Risk Premia (search for similar items in EconPapers)
JEL-codes: E21 E44 G12 (search for similar items in EconPapers)
Date: 1997-07
References: Add references at CitEc
Citations: View citations in EconPapers (17)

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Working Paper: Preferences, Consumption Smoothing and Risk Premia (1997)
Working Paper: Preferences, Consumption Smoothing and Risk Premia (1997)
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