Recursive Preferences, Correlation Aversion, and the Temporal Resolution of Uncertainty
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arXiv
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| Natura: | Preprint |
| Pubblicazione: |
2023
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| _version_ | 1866911536041164800 |
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| author | Stanca, Lorenzo Maria |
| author_facet | Stanca, Lorenzo Maria |
| contents | This paper investigates a novel behavioral feature of recursive preferences: aversion to risks that persist over time, or simply \textit{correlation aversion}. Greater persistence provides information about future consumption but reduces opportunities to hedge consumption risk. I show that, for recursive preferences that exhibit a preference for early resolution of uncertainty, correlation aversion is equivalent to increasing relative risk aversion. To quantify correlation aversion, I develop the concept of the persistence premium, which measures how much an individual is willing to pay to eliminate persistence in consumption. I provide an approximation of the persistence premium in the spirit of Arrow--Pratt, which provides a quantitative representation of the trade-off between information and hedging. I show that correlation-averse preferences have a variational representation, linking correlation aversion to concerns about model misspecification. I present several applications. I first illustrate how correlation aversion shapes portfolio choices, and then show how the persistence premium can improve the calibration of macro-finance models. In an optimal taxation model, I show that recursive preferences -- unlike standard preferences -- lead to redistributive tax policies that increase social mobility. |
| format | Preprint |
| id |
arxiv_https___arxiv_org_abs_2304_04599 |
| institution | arXiv |
| publishDate | 2023 |
| record_format | arxiv |
| spellingShingle | Recursive Preferences, Correlation Aversion, and the Temporal Resolution of Uncertainty Stanca, Lorenzo Maria Theoretical Economics This paper investigates a novel behavioral feature of recursive preferences: aversion to risks that persist over time, or simply \textit{correlation aversion}. Greater persistence provides information about future consumption but reduces opportunities to hedge consumption risk. I show that, for recursive preferences that exhibit a preference for early resolution of uncertainty, correlation aversion is equivalent to increasing relative risk aversion. To quantify correlation aversion, I develop the concept of the persistence premium, which measures how much an individual is willing to pay to eliminate persistence in consumption. I provide an approximation of the persistence premium in the spirit of Arrow--Pratt, which provides a quantitative representation of the trade-off between information and hedging. I show that correlation-averse preferences have a variational representation, linking correlation aversion to concerns about model misspecification. I present several applications. I first illustrate how correlation aversion shapes portfolio choices, and then show how the persistence premium can improve the calibration of macro-finance models. In an optimal taxation model, I show that recursive preferences -- unlike standard preferences -- lead to redistributive tax policies that increase social mobility. |
| title | Recursive Preferences, Correlation Aversion, and the Temporal Resolution of Uncertainty |
| topic | Theoretical Economics |
| url | https://arxiv.org/abs/2304.04599 |