Intertemporal Substitutability, Risk Aversion and Asset Prices

TL;DR

This paper investigates whether the elasticity of intertemporal substitution (EIS) is greater than one by analyzing asset price behavior during stock market panics, linking theoretical models with investor risk aversion.

Contribution

It provides empirical and theoretical analysis suggesting that EIS exceeds one to explain asset price declines during high risk aversion episodes.

Findings

Asset prices decline during panic episodes due to increased risk aversion.

Theoretical models indicate asset prices increase with risk aversion only if EIS > 1.

EIS is inferred to be more than one based on observed market behavior.

Abstract

Is the elasticity of intertemporal substitution (EIS) more or less than one? This question can be answered by confronting theoretical results of asset pricing models with investor behaviour during episodes of stock market panic. If we consider these episodes as periods of high risk aversion, then lower asset prices are in fact associated with higher risk aversion. However, according to theoretical models, risky asset price is an increasing function of the coefficient of risk aversion only if the EIS exceeds unity. It may therefore be concluded that the EIS must be more than one to reconcile theory with the observed stock price decline during periods of panic.