Staff Reports
Horizon-Dependent Risk Aversion and the Timing and Pricing of Uncertainty
Previous title: "Asset Pricing with Horizon-Dependent Risk Aversion"
December 2014 Number 703
Revised April 2019
JEL classification: D03, D90, G02, G12

Authors: Marianne Andries, Thomas Eisenbach, and Martin C. Schmalz

Inspired by experimental evidence, we amend the recursive utility model to let risk aversion decrease with the temporal horizon. Our pseudo-recursive preferences retain appealing features of the standard model and remain analytically tractable. In a macro-finance application, we formally derive the pricing of risk in our framework and confront two major challenges to the long-run risk asset pricing model: that it requires too strong a preference for early resolutions of uncertainty to explain the risk premia observed in the data; and that it cannot explain the evidence on term structures of expected returns, in particular the slope reversals documented during the 2007–09 financial crisis. Both puzzles are solved by introducing horizon-dependent risk aversion.
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