Working Paper: CEPR ID: DP5020
Authors: Harjoat S. Bhamra; Raman Uppal
Abstract: The objective of this paper is to understand the implications for consumption and portfolio choice of the separation of an investor?s risk aversion and elasticity of intertemporal substitution that is made possible by recursive utility, in contrast to expected utility, where the two are governed by the same parameter. In particular, we study exactly how risk aversion and elasticity of intertemporal substitution affect optimal dynamic consumption and portfolio decisions. For a three-date, discrete-time model with a stochastic interest rate, we obtain an exact analytic solution for the optimal consumption and portfolio policies. We find that, in general, the consumption and portfolio decisions depend on both risk aversion and the elasticity of intertemporal substitution. Only in the case where the investment opportunity set is constant, is the optimal portfolio weight independent of the elasticity of intertemporal substitution. We also find that the size of risk aversion relative to unity determines the sign of the intertemporal hedging component in the optimal portfolio, while elasticity of intertemporal substitution affects only the magnitude of the hedging component.
Keywords: decision making; intertemporal optimization
JEL Codes: D81; D91; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk aversion (D81) | optimal consumption and portfolio decisions (G11) |
| risk aversion (D81) | intertemporal hedging component in the optimal portfolio (D15) |
| elasticity of intertemporal substitution (D15) | magnitude of hedging component (G13) |
| changes in investment opportunity set (G11) | consumption (E21) |
| elasticity of intertemporal substitution (D15) | net effect on consumption (E21) |