2012-17 | September 2013
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Risk Aversion, Risk Premia, and the Labor Margin with Generalized Recursive Preferences
A flexible labor margin allows households to absorb shocks to asset values with changes in hours worked as well as changes in consumption. This ability to absorb shocks along both margins greatly alters the household’s attitudes toward risk, as shown by Swanson (2012). The present paper extends that analysis to the case of generalized recursive preferences, as in Epstein and Zin (1989) and Weil (1989), including multiplier preferences, as in Hansen and Sargent (2001). Understanding risk aversion for these preferences is especially important because they are the primary mechanism being used to bring macroeconomic models into closer agreement with asset pricing facts. Measures of risk aversion commonly used in the literature—including traditional, fixed-labor measures and Cobb-Douglas composite-good measures—show no stable relationship to the equity premium in a standard macroeconomic model, while the closed-form expressions derived in this paper match the equity premium closely. Thus, measuring risk aversion correctly—taking into account the household’s labor margin—is necessary for risk aversion to correspond to asset prices in the model.
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