Pricing Assets When Risk Aversion Decreases With the Delay

Abstract

I develop a consumption-based model with a dynamically inconsistent representative agent whose risk aversion decreases with the delay. When this agent is naive, this model generates high equity premia and low interest rates. Moreover, the term structure of equity premia is decreasing. Finally, risk aversion and the market price of risk are counter-cyclical, provided the elasticity of intertemporal substitution is below unity. The preferences are a simple transformation of the standard model. As in the habit formation model of Campbell and Cochrane (1999), risk aversion depends on past consumption. As in the long-run risks model of Bansal and Yaron (2004), counter-cyclicality will depend on news about long-term consumption prospects.