Optimal Risk Sharing with Time Inconsistency and Long-Run Risk

67 Pages Posted: 5 Dec 2019

Date Written: November 16, 2019

Abstract

I examine the role of time inconsistency, modeled by hyperbolic discounting, for the dynamics of asset prices and the wealth distribution between agents. Naive time-inconsistent investors with recursive preferences overconsume and have a lower effective elasticity of intertemporal substitution (EIS) than otherwise similar investors who are time-consistent. In both survival and overlapping-generations economies with i.i.d. consumption growth, I show that the suboptimal consumption and saving decisions of the naive time-inconsistent investors endogenously generate long-run risks in the consumption dynamics of the time-consistent agents. As a result, the presence of naive shortsighted investors increases the risk-free rate, volatility, and risk premium in the economy.

Keywords: Time inconsistency, hyperbolic discounting, long-run risk, risk sharing

JEL Classification: D53, E21, G10, G41

Suggested Citation

Tancheva, Zhaneta, Optimal Risk Sharing with Time Inconsistency and Long-Run Risk (November 16, 2019). Available at SSRN: https://ssrn.com/abstract=3489906 or http://dx.doi.org/10.2139/ssrn.3489906

Zhaneta Tancheva (Contact Author)

Tilburg University ( email )

P.O. Box 90153
Tilburg, DC Noord-Brabant 5000 LE
Netherlands

HOME PAGE: http://https://sites.google.com/site/zhanetatancheva

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