Substitution and Risk Aversion: Is Risk Aversion Important for Understanding Asset Prices?

Abstract

This paper uses a recursive time-non-separable expected utility function to separate between the intertemporal elasticity of substitution (IES) and a measure of relative risk aversion to bets in terms of money (RAM). Risk premium does not require risk aversion. Changes in IES have large effects on asset prices but changes in risk aversion have only a small effect on asset prices. Assuming IES = 1 and allowing a wide range for the RAM coefficient (say between 0 and 10) is consistent with the cross-countries observation made by Lucas (2003) and the net of taxes and net of frictions rates of return estimated by McGrattan and Prescott (2003).