Skip to main content
×
Home
    • Aa
    • Aa

WHY DO RISK PREMIA VARY OVER TIME? A THEORETICAL INVESTIGATION UNDER HABIT FORMATION

  • Bianca De Paoli (a1) and Pawel Zabczyk (a2)
Abstract

We study the dynamics of risk premia in a model with external habit formation and highlight the significance of “recession predictability”. Although under the specification of Campbell and Cochrane, [Journal of Political Economy 107, 205–251 (1999)] the equity risk premium is countercyclical because increases in risk aversion are reinforced by rising recession risks, this need not be the case more generally. We show analytically that in endowment economies procyclical recession expectations can outweigh countercyclical changes in risk aversion, generating counterfactual risk-premium behavior. However, allowing shocks or habits to be sufficiently persistent, or explicitly accounting for the impact of habits on consumption, suffices to generate countercyclical recession risks and risk premia.

Copyright
Corresponding author
Address correspondence to: Bianca De Paoli, Monetary Analysis HO-2, Bank of England, Threadneedle St., London EC2R 8AH, UK; e-mail: bianca.depaoli@bankofengland.co.uk.
Linked references
Hide All

This list contains references from the content that can be linked to their source. For a full set of references and notes please see the PDF or HTML where available.

Ravi Bansal and Amir Yaron (2004) Risks for the long run: A potential resolution of asset pricing puzzles. Journal of Finance 59, 14811509.

John Y. Campbell and John H. Cochrane (1999) By force of habit: A consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205251.

John Y. Campbell and John H. Cochrane (2000) Explaining the poor performance of consumption-based asset pricing models. Journal of Finance 55, 28632878.

John Y. Campbell and J. Robert Shiller (1991) Yield spread and interest rate movements: A bird's eye view. Review of Economic Studies 58, 495514.

Christopher D. Carroll , Jiri Slacalek , and Martin Sommer (2011) International evidence on sticky consumption growth. Review of Economics and Statistics 93 (4), 11351145.

Xiaohong Chen and Sydney C. Ludvigson (2009) Land of addicts? An empirical investigation of habit-based asset pricing models. Journal of Applied Economics 24 (7), 10571093.

Lawrence J. Christiano , Martin Eichenbaum , and Charles L. Evans (2005) Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy 113, 145.

John H. Cochrane and Monika Piazzesi (2005) Bond risk premia. American Economic Review 95, 138160.

Fabrice Collard , Patrick Feve , and Imen Ghattassi (2006) Predictability and habit persistence. Journal of Economic Dynamics and Control 30, 22172260.

Wouter den Haan (1995) The term structure of interest rates in real and monetary economies. Journal of Economic Dynamics and Control 19, 909940.

Karen E. Dynan (2000) Habit formation in consumer preferences: Evidence from panel data. American Economic Review 90, 391406.

Jeffrey C. Fuhrer (2000) Habit formation in consumption and its implications for monetary-policy models. American Economic Review 90, 367390.

Campbell R. Harvey (1989) Time-varying conditional covariances in tests of asset pricing models. Journal of Financial Economics 24, 289317.

Peter Hordahl , Oreste Tristani , and David Vestin (2008) The yield curve and macroeconomic dynamics. Economic Journal 118, 19371970.

Urban J. Jermann (1998) Asset pricing in production economies. Journal of Monetary Economics 41, 257275.

Shmuel Kandel and Robert F. Stambaugh (1990) Expectations and volatility of consumption and asset returns. Review of Financial Studies 3, 207232.

George Li (2007) Time-varying risk aversion and asset prices. Journal of Banking and Finance 31, 243257.

Yuming Li (2001) Expected returns and habit persistence. Review of Financial Studies 14, 861899.

Robert E. Lucas Jr., (1978) Asset prices in an exchange economy. Econometrica 46, 14291445.

Hanno Lustig and Adrien Verdelhan (2007) The cross section of foreign currency risk premia and consumption growth risk. American Economic Review 97, 89117.

Rajnish Mehra and Edward C. Prescott (1985) The equity premium: A puzzle. Journal of Monetary Economics 15, 145161.

Glenn Rudebusch and Eric Swanson (2008) Examining the bond premium puzzle with a DSGE model. Journal of Monetary Economics 55, S111S126.

Stephanie Schmitt-Grohe and Martin Uribe (2004) Solving dynamic general equilibrium models using a second-order approximation to the policy function. Journal of Economic Dynamics and Control 28, 755775.

Frank Smets and Rafael Wouters (2007) Shocks and frictions in US business cycles: A Bayesian DSGE approach. American Economic Review 97, 586606.

Harald Uhlig (2007) Explaining asset prices with external habits and wage rigidities in a DSGE model. American Economic Review 97, 239243.

Adrien Verdelhan (2010) A habit-based explanation of the exchange rate risk premium. Journal of Finance 65, 123146.

Jessica A. Wachter (2006) A consumption-based model of the term structure of interest rates. Journal of Financial Economics 79, 365399.

Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Macroeconomic Dynamics
  • ISSN: 1365-1005
  • EISSN: 1469-8056
  • URL: /core/journals/macroeconomic-dynamics
Please enter your name
Please enter a valid email address
Who would you like to send this to? *
×

Keywords: