The sensitivity of risk premiums to the elasticity of intertemporal substitution

This paper incorporates reference-dependent preferences into a consumption-based asset pricing model featuring Epstein-Zin utility. Three relevant results emerge from this extension. First, agents prefer the late resolution of uncertainty in recursive utility. Second, the late resolution of uncertainty helps replicate the downward-sloping term structure of market excess return. Third, the intertemporal substitution elasticity is more sensitive to asset prices through increasing precautionary saving motivations. A closed-form solution for the proposed model largely explains (i) high, volatile, and countercyclical equity premiums; (ii) low risk-free rates; and (iii) the downward-sloping term structure of equity premiums and variance ratios.