Data Management

Can Risk Aversion Really Explain The Negative Investment-Uncertainty Relationship?

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Executive Summary

This paper shows the role of risk aversion and intertemporal substitutability in the investment-uncertainty relationship. Using recursive preferences, the paper demonstrates that not only the degree of risk aversion is important in determining the sign of the investment uncertainty relationship but that the intertemporal substitution elasticity also plays a crucial role. This cannot be captured in the traditional expected utility set-up as risk aversion and intertemporal substitutability are determined by the same parameter. In particular, the paper shows that risk aversion can explain the negative relationship between investment and uncertainty only in a static context.

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