Horizon-Dependent Risk Aversion and the Timing and Pricing of Uncertainty

Andries, Marianne; Eisenbach, Thomas M.; Schmalz, Martin C.

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Horizon-Dependent Risk Aversion and the Timing and Pricing of Uncertainty

Abstract: Inspired by experimental evidence, we amend the recursive utility model to let risk aversion decrease with the temporal horizon. Our pseudo-recursive preferences remain tractable and retain appealing features of the long-run risk framework, notably its success at explaining asset pricing moments. In addition, our model addresses two challenges to the standard model. Calibrating the agents’ preferences to explain the equity premium no longer implies an extreme preference for early resolutions of uncertainty. Horizondependent risk aversion helps resolve key puzzles in finance on the valuation of assets across maturities and captures the term structure of equity risk premia and its dynamics.

JEL Classification: D90; G12;