Department of Economics and Business Economics

Explaining Asset Prices with Low Risk Aversion and Low Intertemporal Substitution

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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.
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages40
Publication statusPublished - 10 May 2016
SeriesCREATES Research Papers
Number2016-16

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