How risk aversion shapes the trade-off between commitment and flexibility

Abstract

We use a three-period model to explore the optimal asset transfer that a present self, aware that her near future self is present-biased but better informed, will make to protect her far future self against income shocks. The model captures the present self’s trade-off between using illiquid savings as a commitment mechanism, restricting the near future self from its consumption temptations; and giving flexibility to the near future self to adjust consumption after knowing the shock size. We adopt a class of utility functions, à la Epstein–Zin, to vary risk aversion while holding time preferences fixed. Our main result states that a more risk-averse agent would purchase more illiquid assets.