Substitution, Risk Aversion, Taste Shocks and Equity Premia

CREFE Working Paper 39

Posted: 13 Apr 1998

See all articles by Michel Normandin

Michel Normandin

HEC Montreal - Institute of Applied Economics

Pascal St-Amour

University of Lausanne - School of Economics and Business Administration (HEC-Lausanne); Swiss Finance Institute

Date Written: January 1996

Abstract

This paper investigates the testable restrictions on the time-series behavior of equity premia implied by a representative agent model whose state- and time-non separable preferences are subject to taste shocks. The model nests state- and time-separable preferences with and without taste shocks as special cases. Empirically, the linearized Euler equations are estimated through Kalman filtering, allowing for conditional heteroscedasticity via a common factor GARCH process. With or without conditional heteroscedasticity, (i) the hypothesis that preferences are separable cannot be rejected, (ii) taste shocks influences are statistically significant, and (iii) taste shocks yield reasonable estimates of the coefficient of relative risk aversion. This last result occurs because taste shocks reproduce the large observed equity premium by shifting weight away from consumption risk in favor to taste risk.

JEL Classification: G12, C12, C32

Suggested Citation

Normandin, Michel and St-Amour, Pascal, Substitution, Risk Aversion, Taste Shocks and Equity Premia (January 1996). CREFE Working Paper 39. Available at SSRN: https://ssrn.com/abstract=7705

Michel Normandin (Contact Author)

HEC Montreal - Institute of Applied Economics ( email )

3000, ch. de la Côte-Ste-Catherine
Montréal, Quebec H3T 2A7
Canada

Pascal St-Amour

University of Lausanne - School of Economics and Business Administration (HEC-Lausanne) ( email )

Unil Dorigny, Batiment Internef
Lausanne, 1015
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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