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Open Access Publications from the University of California

Can We Disentangle Risk Aversion from Intertemporal Substitution in Consumption

  • Author(s): Schwartz, Eduardo
  • Torous, Walter N.
  • et al.

vThe consumption asset pricing framework implies that asset prices may be used to investigate the properties of consumption. An important property of consumption is its elasticity of intertemporal substitution which measures the willingness of individuals to move consumption between time periods in response to changes in interest rates and has important implications for the effectiveness of monetary policy and the behavior of the business cycle. However, consumption asset pricing models typically assume a power utility function in which the elasticity of intertemporal substitution cannot be disentangled from the coefficient of relative risk aversion. While the Epstein-Zin utility function breaks this link, extant empirical tests of this specification have not been able to disentangle these parameter. We argue that this failure arises because data previously used does not properly capture the time dimension needed to accurately estimate the elasticity of intertemporal substitution. We use term structure data, in particular “forward” portfolios which more accurately measure movements across points on the term structure. We find that the Epstein-Zin specification is consistent with out term structure data and we are able to clearly disentangle the elasticity of intertemporal substitution from the coefficient of relative risk aversion.

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