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Why Do Risk Premia Vary Over Time? A Theoretical Investigation Under Habit Formation

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  • De Paoli, Bianca
  • Zabczyk, Pawel

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.

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  • De Paoli, Bianca & Zabczyk, Pawel, 2012. "Why Do Risk Premia Vary Over Time? A Theoretical Investigation Under Habit Formation," Macroeconomic Dynamics, Cambridge University Press, vol. 16(S2), pages 252-266, September.
    • Handle: RePEc:cup:macdyn:v:16:y:2012:i:s2:p:252-266_00
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    1. Should Monetary Policy Respond to Financial Conditions?
      by Blog Author in Liberty Street Economics on 2015-11-16 18:00:00

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    Cited by:

    1. John Fry, 2014. "Bubbles, shocks and elementary technical trading strategies," The European Physical Journal B: Condensed Matter and Complex Systems, Springer;EDP Sciences, vol. 87(1), pages 1-13, January.
    2. Silvia Miranda-Agrippino, 2015. "Unsurprising Shocks: Information, Premia, and the Monetary Transmission," Discussion Papers 1613, Centre for Macroeconomics (CFM), revised Apr 2016.
    3. Bianca De Paoli & Jens Søndergaard, 2017. "Revisiting the Forward Premium Anomaly Using Consumption Habits: A New Keynesian Model," Economica, London School of Economics and Political Science, vol. 84(335), pages 516-540, July.
    4. Bianca De Paoli & Pawel Zabczyk, 2013. "Cyclical Risk Aversion, Precautionary Saving, and Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(1), pages 1-36, February.
    5. Hatcher, Michael, 2011. "Time-varying volatility, precautionary saving and monetary policy," Bank of England working papers 440, Bank of England.
    6. Haitham A. Al-Zoubi, 2017. "Cyclical and Persistent Carry Trade Returns and Forward Premia," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 7(04), pages 1-33, December.
    7. De Paoli, Bianca & Sondergaard, Jens, 2009. "Foreign exchange rate risk in a small open economy," Bank of England working papers 365, Bank of England.

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