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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

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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Bibliographic Info

Article provided by Cambridge University Press in its journal Macroeconomic Dynamics.

Volume (Year): 16 (2012)
Issue (Month): S2 (September)
Pages: 252-266

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Handle: RePEc:cup:macdyn:v:16:y:2012:i:s2:p:252-266_00

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  1. Adrien Verdelhan, 2010. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Journal of Finance, American Finance Association, vol. 65(1), pages 123-146, 02.
  2. Hanno Lustig & Adrien Verdelhan, 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2006-045, Boston University - Department of Economics.
  3. Bianca De Paoli, Alasdair Scott, Olaf Weeken, 2007. "Asset pricing implications for a New Keynesian model," Money Macro and Finance (MMF) Research Group Conference 2006 156, Money Macro and Finance Research Group.
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Cited by:
  1. Hatcher, Michael, 2011. "Time-varying volatility, precautionary saving and monetary policy," Bank of England working papers 440, Bank of England.
  2. Bianca De Paoli & Pawel Zabczyk, 2012. "Cyclical Risk Aversion, Precautionary Saving and Monetary Policy," CEP Discussion Papers dp1132, Centre for Economic Performance, LSE.
  3. De Paoli, Bianca & Sondergaard, Jens, 2009. "Foreign exchange rate risk in a small open economy," Bank of England working papers 365, Bank of England.
  4. Fry, John, 2013. "Bubbles, shocks and elementary technical trading strategies," MPRA Paper 47052, University Library of Munich, Germany.

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