Preferences, Consumption Smoothing and Risk Premia

M. Lettau, H.F.H.V.S. Uhlig

Research output: Working paperDiscussion paperOther research output

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Abstract

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.
Original languageEnglish
Place of PublicationTilburg
PublisherMacroeconomics
Number of pages35
Volume1997-60
Publication statusPublished - 1997

Publication series

NameCentER Discussion Paper
Volume1997-60

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Consumption smoothing
Risk premia
Elasticity
Elasticity of intertemporal substitution
Sharpe ratio
Habit formation
Dividends
Coefficients
Decomposition
Risk-return trade-off
Capital asset pricing model
Risk-return tradeoff
Relative risk aversion
Complete markets
Asset pricing
Stochastic discount factor
Innovation

Keywords

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

Cite this

Lettau, M., & Uhlig, H. F. H. V. S. (1997). Preferences, Consumption Smoothing and Risk Premia. (CentER Discussion Paper; Vol. 1997-60). Tilburg: Macroeconomics.
Lettau, M. ; Uhlig, H.F.H.V.S. / Preferences, Consumption Smoothing and Risk Premia. Tilburg : Macroeconomics, 1997. (CentER Discussion Paper).
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Lettau, M & Uhlig, HFHVS 1997 'Preferences, Consumption Smoothing and Risk Premia' CentER Discussion Paper, vol. 1997-60, Macroeconomics, Tilburg.

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

Tilburg : Macroeconomics, 1997. (CentER Discussion Paper; Vol. 1997-60).

Research output: Working paperDiscussion paperOther research output

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Lettau M, Uhlig HFHVS. Preferences, Consumption Smoothing and Risk Premia. Tilburg: Macroeconomics. 1997. (CentER Discussion Paper).