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Explaining Asset Prices with Low Risk Aversion and Low Intertemporal Substitution

Author

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  • Martin M. Andreasen

    (Aarhus University and CREATES)

  • Kasper Jørgensen

    (Aarhus University and CREATES)

Abstract

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.

Suggested Citation

  • Martin M. Andreasen & Kasper Jørgensen, 2016. "Explaining Asset Prices with Low Risk Aversion and Low Intertemporal Substitution," CREATES Research Papers 2016-16, Department of Economics and Business Economics, Aarhus University.
    • Handle: RePEc:aah:create:2016-16
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    References listed on IDEAS

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    More about this item

    Keywords

    Bond premium puzzle; Equity premium puzzle; Long-run risk; Perturbation Approximation; Risk-free rate puzzle.;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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