Skip to main content
×
×
Home

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.
References
Hide All
Bansal Ravi and Yaron Amir (2004) Risks for the long run: A potential resolution of asset pricing puzzles. Journal of Finance 59, 14811509.
Campbell John Y. and Cochrane John H. (1999) By force of habit: A consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205251.
Campbell John Y. and Cochrane John H. (2000) Explaining the poor performance of consumption-based asset pricing models. Journal of Finance 55, 28632878.
Campbell John Y., Lo Andrew W., and MacKinlay A. Craig (1997) The Econometrics of Financial Markets. Princeton, NJ: Princeton University Press.
Campbell John Y. and Shiller J. Robert (1991) Yield spread and interest rate movements: A bird's eye view. Review of Economic Studies 58, 495514.
Carroll Christopher D., Slacalek Jiri, and Sommer Martin (2011) International evidence on sticky consumption growth. Review of Economics and Statistics 93 (4), 11351145.
Chen Xiaohong and Ludvigson Sydney C. (2009) Land of addicts? An empirical investigation of habit-based asset pricing models. Journal of Applied Economics 24 (7), 10571093.
Christiano Lawrence J., Eichenbaum Martin, and Evans Charles L. (2005) Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy 113, 145.
Cochrane John H. and Piazzesi Monika (2005) Bond risk premia. American Economic Review 95, 138160.
Collard Fabrice, Feve Patrick, and Ghattassi Imen (2006) Predictability and habit persistence. Journal of Economic Dynamics and Control 30, 22172260.
den Haan Wouter (1995) The term structure of interest rates in real and monetary economies. Journal of Economic Dynamics and Control 19, 909940.
De Paoli, Alasdair Scott Bianca, and Weeken Olaf (2010) Asset pricing implications of a New Keynesian model. Journal of Economic Dynamics and Control 34 (10), 20562073.
Dynan Karen E. (2000) Habit formation in consumer preferences: Evidence from panel data. American Economic Review 90, 391406.
Fuhrer Jeffrey C. (2000) Habit formation in consumption and its implications for monetary-policy models. American Economic Review 90, 367390.
Garleanu Nicolae and Panageas Stavros (2008) Young, Old, Conservative and Bold: The Implications of Heterogeneity and Finite Lives for Asset Pricing. Mimeo, Chicago GSB.
Harvey Campbell R. (1989) Time-varying conditional covariances in tests of asset pricing models. Journal of Financial Economics 24, 289317.
Hordahl Peter, Tristani Oreste, and Vestin David (2008) The yield curve and macroeconomic dynamics. Economic Journal 118, 19371970.
Jermann Urban J. (1998) Asset pricing in production economies. Journal of Monetary Economics 41, 257275.
Kandel Shmuel and Stambaugh Robert F. (1990) Expectations and volatility of consumption and asset returns. Review of Financial Studies 3, 207232.
Li George (2007) Time-varying risk aversion and asset prices. Journal of Banking and Finance 31, 243257.
Li Yuming (2001) Expected returns and habit persistence. Review of Financial Studies 14, 861899.
Lucas Robert E. Jr., (1978) Asset prices in an exchange economy. Econometrica 46, 14291445.
Lustig Hanno and Verdelhan Adrien (2007) The cross section of foreign currency risk premia and consumption growth risk. American Economic Review 97, 89117.
Mehra Rajnish and Prescott Edward C. (1985) The equity premium: A puzzle. Journal of Monetary Economics 15, 145161.
Rudebusch Glenn and Swanson Eric (2008) Examining the bond premium puzzle with a DSGE model. Journal of Monetary Economics 55, S111S126.
Schmitt-Grohe Stephanie and Uribe Martin (2004) Solving dynamic general equilibrium models using a second-order approximation to the policy function. Journal of Economic Dynamics and Control 28, 755775.
Smets Frank and Wouters Rafael (2007) Shocks and frictions in US business cycles: A Bayesian DSGE approach. American Economic Review 97, 586606.
Uhlig Harald (2007) Explaining asset prices with external habits and wage rigidities in a DSGE model. American Economic Review 97, 239243.
Verdelhan Adrien (2010) A habit-based explanation of the exchange rate risk premium. Journal of Finance 65, 123146.
Wachter Jessica A. (2006) A consumption-based model of the term structure of interest rates. Journal of Financial Economics 79, 365399.
Zabczyk Pawel (2008) Closed Form Solutions for Asset Prices in a Difference-Form External Habit Model. Mimeo, London School of Economics.
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:

Metrics

Full text views

Total number of HTML views: 0
Total number of PDF views: 35 *
Loading metrics...

Abstract views

Total abstract views: 291 *
Loading metrics...

* Views captured on Cambridge Core between September 2016 - 21st January 2018. This data will be updated every 24 hours.