### Abstract

Original language | English |
---|---|

Place of Publication | Tilburg |

Publisher | Macroeconomics |

Number of pages | 35 |

Volume | 1997-60 |

Publication status | Published - 1997 |

### Publication series

Name | CentER Discussion Paper |
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Volume | 1997-60 |

### Fingerprint

### Keywords

- risk premium
- consumption
- capital asset pricing
- preferences
- dividend

### Cite this

*Preferences, Consumption Smoothing and Risk Premia*. (CentER Discussion Paper; Vol. 1997-60). Tilburg: Macroeconomics.

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**Preferences, Consumption Smoothing and Risk Premia.** / Lettau, M.; Uhlig, H.F.H.V.S.

Research output: Working paper › Discussion paper › Other research output

TY - UNPB

T1 - Preferences, Consumption Smoothing and Risk Premia

AU - Lettau, M.

AU - Uhlig, H.F.H.V.S.

N1 - Pagination: 35

PY - 1997

Y1 - 1997

N2 - Risk premia in the consumption capital asset pricing model depend on preferences and dividend. We develop a decomposition which allows a separate treatment of both components. We show that preferences alone determine the risk-return tradeoff measured by the Sharpe-ratio. In general, the risk-return trade-off implied by preferences depends on the elasticity of a preference-based stochastic discount factor for pricing assets with respect to the consumption innovation. Depending on the particular specification of preferences, the absolute value of this elasticity can coincide to the inverse of the elasticity of intertemporal substitution (e.g. for habit formation preferences) or the coefficient of relative risk-aversion (e.g. for Epstein-Zin preferences). We demonstrate that preferences based on a small elasticity of intertemporal substitution, such as habit formation, produce small risk premia once agents are allowed to save. Departing from the complete markets framework, we show that uninsurable risk can only increase the Sharpe-ratio and risk premia if dividends are correlated with individual consumption.

AB - Risk premia in the consumption capital asset pricing model depend on preferences and dividend. We develop a decomposition which allows a separate treatment of both components. We show that preferences alone determine the risk-return tradeoff measured by the Sharpe-ratio. In general, the risk-return trade-off implied by preferences depends on the elasticity of a preference-based stochastic discount factor for pricing assets with respect to the consumption innovation. Depending on the particular specification of preferences, the absolute value of this elasticity can coincide to the inverse of the elasticity of intertemporal substitution (e.g. for habit formation preferences) or the coefficient of relative risk-aversion (e.g. for Epstein-Zin preferences). We demonstrate that preferences based on a small elasticity of intertemporal substitution, such as habit formation, produce small risk premia once agents are allowed to save. Departing from the complete markets framework, we show that uninsurable risk can only increase the Sharpe-ratio and risk premia if dividends are correlated with individual consumption.

KW - risk premium

KW - consumption

KW - capital asset pricing

KW - preferences

KW - dividend

M3 - Discussion paper

VL - 1997-60

T3 - CentER Discussion Paper

BT - Preferences, Consumption Smoothing and Risk Premia

PB - Macroeconomics

CY - Tilburg

ER -