Hostname: page-component-78c5997874-m6dg7 Total loading time: 0 Render date: 2024-11-19T11:50:36.219Z Has data issue: false hasContentIssue false
  • English
  • Français

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

Published online by Cambridge University Press:  13 February 2012

Bianca De Paoli  and
Pawel Zabczyk
Bianca De Paoli*
Affiliation:
Centre for Economic Performance London School of Economics and Bank of England
Pawel Zabczyk
Affiliation:
European Central Bank and Bank of England
*
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.
Get access Rights & Permissions [Opens in a new window]

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.

Keywords

Risk PremiumHabitsCountercyclicalityMacrofinance
Type
Articles
Information
Macroeconomic Dynamics , Volume 16 , Supplement S2: Time-Varying Modeling with Macroeconomic and Financial Data , September 2012 , pp. 252 - 266
Copyright
Copyright © Cambridge University Press 2012

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

REFERENCES

Bansal, Ravi and Yaron, Amir (2004) Risks for the long run: A potential resolution of asset pricing puzzles. Journal of Finance 59, 1481–1509.Google Scholar
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, 205–251.Google Scholar
Campbell, John Y. and Cochrane, John H. (2000) Explaining the poor performance of consumption-based asset pricing models. Journal of Finance 55, 2863–2878.Google Scholar
Campbell, John Y., Lo, Andrew W., and MacKinlay, A. Craig (1997) The Econometrics of Financial Markets. Princeton, NJ: Princeton University Press.Google Scholar
Campbell, John Y. and Shiller, J. Robert (1991) Yield spread and interest rate movements: A bird's eye view. Review of Economic Studies 58, 495–514.Google Scholar
Carroll, Christopher D., Slacalek, Jiri, and Sommer, Martin (2011) International evidence on sticky consumption growth. Review of Economics and Statistics 93 (4), 1135–1145.Google Scholar
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), 1057–1093.Google Scholar
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, 1–45.Google Scholar
Cochrane, John H. and Piazzesi, Monika (2005) Bond risk premia. American Economic Review 95, 138–160.Google Scholar
Collard, Fabrice, Feve, Patrick, and Ghattassi, Imen (2006) Predictability and habit persistence. Journal of Economic Dynamics and Control 30, 2217–2260.CrossRefGoogle Scholar
den Haan, Wouter (1995) The term structure of interest rates in real and monetary economies. Journal of Economic Dynamics and Control 19, 909–940.Google Scholar
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), 2056–2073.Google Scholar
Dynan, Karen E. (2000) Habit formation in consumer preferences: Evidence from panel data. American Economic Review 90, 391–406.Google Scholar
Fuhrer, Jeffrey C. (2000) Habit formation in consumption and its implications for monetary-policy models. American Economic Review 90, 367–390.Google Scholar
Garleanu, Nicolae and Panageas, Stavros (2008) Young, Old, Conservative and Bold: The Implications of Heterogeneity and Finite Lives for Asset Pricing. Mimeo, Chicago GSB.Google Scholar
Harvey, Campbell R. (1989) Time-varying conditional covariances in tests of asset pricing models. Journal of Financial Economics 24, 289–317.Google Scholar
Hordahl, Peter, Tristani, Oreste, and Vestin, David (2008) The yield curve and macroeconomic dynamics. Economic Journal 118, 1937–1970.Google Scholar
Jermann, Urban J. (1998) Asset pricing in production economies. Journal of Monetary Economics 41, 257–275.Google Scholar
Kandel, Shmuel and Stambaugh, Robert F. (1990) Expectations and volatility of consumption and asset returns. Review of Financial Studies 3, 207–232.Google Scholar
Li, George (2007) Time-varying risk aversion and asset prices. Journal of Banking and Finance 31, 243–257.Google Scholar
Li, Yuming (2001) Expected returns and habit persistence. Review of Financial Studies 14, 861–899.Google Scholar
Lucas, Robert E. Jr., (1978) Asset prices in an exchange economy. Econometrica 46, 1429–1445.CrossRefGoogle Scholar
Lustig, Hanno and Verdelhan, Adrien (2007) The cross section of foreign currency risk premia and consumption growth risk. American Economic Review 97, 89–117.Google Scholar
Mehra, Rajnish and Prescott, Edward C. (1985) The equity premium: A puzzle. Journal of Monetary Economics 15, 145–161.Google Scholar
Rudebusch, Glenn and Swanson, Eric (2008) Examining the bond premium puzzle with a DSGE model. Journal of Monetary Economics 55, S111–S126.Google Scholar
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, 755–775.Google Scholar
Smets, Frank and Wouters, Rafael (2007) Shocks and frictions in US business cycles: A Bayesian DSGE approach. American Economic Review 97, 586–606.Google Scholar
Uhlig, Harald (2007) Explaining asset prices with external habits and wage rigidities in a DSGE model. American Economic Review 97, 239–243.Google Scholar
Verdelhan, Adrien (2010) A habit-based explanation of the exchange rate risk premium. Journal of Finance 65, 123–146.Google Scholar
Wachter, Jessica A. (2006) A consumption-based model of the term structure of interest rates. Journal of Financial Economics 79, 365–399.Google Scholar
Zabczyk, Pawel (2008) Closed Form Solutions for Asset Prices in a Difference-Form External Habit Model. Mimeo, London School of Economics.Google Scholar