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 either or both margins greatly alters the household’s attitudes toward risk, as shown by Swanson (2012). The present paper extends that work to the case of generalized recursive preferences, as in Epstein and Zin (1989) and Weil (1989), which are increasingly being used to bring macroeconomic models into closer agreement with basic asset pricing facts. Measures of risk aversion commonly used in the literature show no stable relationship to the equity premium in a standard RBC model, while the closed-form expressions derived in this paper match the equity premium closely. Thus, measuring risk aversion correctly is crucial for understanding asset prices in the model.