Why do risk premia vary over time? A theoretical investigation under habit formation

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 29 January 2009

Working Paper No. 361
By Bianca De Paoli and Pawel Zabczyk

Empirical evidence suggests that risk premia are higher at business cycle troughs than they are at peaks. Existing asset pricing theories ascribe moves in risk premia to changes in volatility or risk aversion. Nevertheless, in a simple general equilibrium model, risk premia can be procyclical even though the volatility of consumption is constant and despite a countercyclically varying risk aversion coefficient. We show that agents’ expectations about future prospects also influence premium dynamics. In order to generate countercyclically varying premia, as found in the data, one requires a combination of hump-shaped consumption dynamics or highly persistent shocks and habits. Our results, thus, suggest that factors which help match activity data may also help along the asset pricing dimension.

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