The Role of Risk Aversion and Intertemporal Substitution in Dynamic Consumption-Portfolio Choicewith Recursive Utility

Raman Uppal and Harjoat Bhamra

No 5020, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: The objective of this paper is to understand the implications for consumption and portfolio choice of the separation of an investor?s risk aversion and elasticity of intertemporal substitution that is made possible by recursive utility, in contrast to expected utility, where the two are governed by the same parameter. In particular, we study exactly how risk aversion and elasticity of intertemporal substitution affect optimal dynamic consumption and portfolio decisions. For a three-date, discrete-time model with a stochastic interest rate, we obtain an exact analytic solution for the optimal consumption and portfolio policies. We find that, in general, the consumption and portfolio decisions depend on both risk aversion and the elasticity of intertemporal substitution. Only in the case where the investment opportunity set is constant, is the optimal portfolio weight independent of the elasticity of intertemporal substitution. We also find that the size of risk aversion relative to unity determines the sign of the intertemporal hedging component in the optimal portfolio, while elasticity of intertemporal substitution affects only the magnitude of the hedging component.

Keywords: Intertemporal optimization; Decision making (search for similar items in EconPapers)
JEL-codes: D81 D91 G11 (search for similar items in EconPapers)
Date: 2005-04
New Economics Papers: this item is included in nep-fin
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Citations: View citations in EconPapers (1)

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Journal Article: The role of risk aversion and intertemporal substitution in dynamic consumption-portfolio choice with recursive utility (2006)
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