Abstract
The main message of this paper is that it is Elasticity of Intertemporal Substitution, which is at the heart of the asset pricing puzzles, not Risk Aversion. We illustrate that point, by first showing that under certainty a model, which allows for a separation of the two characteristics of preferences - the one in Epstein and Zin (1991), leads to a specification of the main pricing equation, which involves a measure of Elasticity of Intertemporal Substitution only and not a measure of Risk Aversion. We then resort to an approximation of the main asset pricing equation under uncertainty, to demonstrate the central role played by Elasticity of Intertemporal Substitution and to emphasize the importance of its variability. We illustrate that importance by showing that the model in Campbell and Cochrane (1999) is in fact based on time-varying Elasticity of Intertemporal Substitution rather then on time-varying Risk Aversion. The main contribution of the paper is to develop a discrete-time alternative to the two most popular recursive utility based asset pricing models. The model proposed in the paper, directly nests the standard one, while replicating and improving upon the two frequently cited advantages of the Epstein-Zin model. It allows for time-varying risk premia, associated with the two most popular asset pricing factors and it achieves separation of risk attitudes from attitudes towards time via constant relative risk aversion (CRRA) and time-varying Elasticity of Intertemporal Substitution.
Published Version
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