Counter-cyclical risk aversion

The paper proposes a consistent estimator of time-varying risk aversion in consumption-based CAPM. Based on the Epstein-Zin-Weil (Epstein and Zin, 1989, 1991; Weil, 1989) recursive utility, we derive the Euler equation in which risk aversion is a non-parametric function of time. The proxy variable method is utilized to replace the unobserved return to aggregate wealth in the Euler equation. The estimation of risk aversion is carried out based on a two-stage local-linear regression method. Given the estimate, we investigate the conventional wisdom in economics that risk aversion is counter-cyclical. The empirical results strongly support the counter-cyclicality of the risk aversion parameter.