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Intertemporal Substitution and Equity Premium

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  • Wei Yang

Abstract

This article presents a model that incorporates habit formation and long-run risks into the Epstein–Zin preferences, and reveals intertemporal substitution as a distinctive channel, separate from risk aversion, in generating key asset market phenomena. With habit formation, both the risk aversion and intertemporal substitution channels enhance the market price of short-run consumption risk. With long-run risks, intertemporal substitution reduces the market prices of long-run consumption risks, working against risk aversion. The contrasting effects of the intertemporal substitution channel drive key differences in the model implications of habit formation and long-run risks.

Suggested Citation

  • Wei Yang, 2016. "Intertemporal Substitution and Equity Premium," Review of Finance, European Finance Association, vol. 20(1), pages 403-445.
    • Handle: RePEc:oup:revfin:v:20:y:2016:i:1:p:403-445.
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    File URL: http://hdl.handle.net/10.1093/rof/rfv004
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    References listed on IDEAS

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    1. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
    2. Eichenbaum, Martin & Hansen, Lars Peter, 1990. "Estimating Models with Intertemporal Substitution Using Aggregate Time Series Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 53-69, January.
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    3. Suzuki, Masataka, 2024. "A consumption-based term structure model of bonds and equity," International Review of Financial Analysis, Elsevier, vol. 94(C).

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