Revisiting Asset Pricing with Uncertainty in Future Risk Aversion

Abstract

In asset pricing models, the indirect synchronizations of changes in time-varying relative risk aversion (RRA) with changes in elasticity of intertemporal substitution (EIS) and/or changes in consumption growth are overlooked confounding factors that limit our understanding of the role of time-varying RRA in asset pricing. I isolate away time-varying RRA from the confounders of perfectly synchronized changes in EIS and consumption growth and from other complexities. Holding EIS fixed under recursive utility and relaxing perfect correlation between RRA and consumption growth, I show that rare and short-lived stochastic shifts in RRA can explain major empirical asset pricing facts.

Keywords: equity premium puzzle, elasticity of intertemporal substitution, Epstein-Zin preferences, time-varying risk aversion, predictability

JEL Classification: G12, E44, G02