Age‐Dependent Increasing Risk Aversion and the Equity Premium Puzzle

Amadeu DaSilva, Mira Farka and Christos Giannikos

The Financial Review, 2019, vol. 54, issue 2, 377-412

Abstract: We introduce a new preference structure—age‐dependent increasing risk aversion (IRA)—in a three‐period overlapping generations model with borrowing constraints, and examine the behavior of equity premium in this framework. We find that IRA preferences generate results that are more consistent with U.S. data for the equity premium, level of savings and portfolio shares, without assuming unreasonable levels of risk aversion. We find that the relative difference between the two risk aversions (how much more risk‐averse old agents are relative to the middle‐aged) matters more than the average risk aversion in the economy (how much more risk‐averse both cohorts are). Our findings are robust with respect to a number of model generalizations.

Date: 2019
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