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Time-Varying Risk Perceptions and the Pricing of Risky Assets

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  • Friedman, Benjamin M
  • Kuttner, Kenneth N

Abstract

Empirical results based on two different statistical approaches lead to several conclusions about the role of time-varying asset risk assessments in accounting for what, on the basis of many earlier studies, appear to be time-varying differentials in ex ante asset returns. First, both methods indicate sizeable changes over time in variance-covariance structures conditional on past information. These changing conditional variance-covariance structures in turn imply sizeable changes over time in asset demand behavior, and hence in the market-clearing equilibrium structure of ex ante asset returns. Second, at least for some values of the parameter indicating how rapidly investors discount the information contained in past observations, the implied ex ante excess returns bear non-negligible correlation to observed ex post excess returns on either debt or equity. The percentage of the variation of ex post excess returns explained by the implied time-varying ex ante excess returns is comparable to values to which previous researchers have interpreted as warranting rejection of the hypothesis that risk premia are constant over time. Third, although for long-term debt the two statistical methods used here give sharply different answers to the question of how much relevance market participants associate with past observations in assessing future risks, for equities both methods agree in indicating extremely rapid discounting of more distant observations -- so much so that in neither case do outcomes more than a year in the past matter much at all. While the paper's other conclusions are plausible enough, the finding of such an extremely short "memory" on the part of equity investors suggests that the standard representation of equity risk by a single normally distributed disturbance is overly restrictive.

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Bibliographic Info

Article provided by Oxford University Press in its journal Oxford Economic Papers.

Volume (Year): 44 (1992)
Issue (Month): 4 (October)
Pages: 566-98

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Handle: RePEc:oup:oxecpp:v:44:y:1992:i:4:p:566-98

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References

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  1. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, Elsevier, vol. 13(3), pages 341-360, December.
  2. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, American Economic Association, vol. 65(5), pages 900-922, December.
  3. Benjamin M. Friedman & V. Vance Roley, 1985. "Aspects of Investor Behavior Under Risk," NBER Working Papers 1611, National Bureau of Economic Research, Inc.
  4. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 96(1), pages 116-31, February.
  5. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, Econometric Society, vol. 55(2), pages 391-407, March.
  6. Friedman, Benjamin M, 1980. "Price Inflation, Portfolio Choice, and Nominal Interest Rates," American Economic Review, American Economic Association, American Economic Association, vol. 70(1), pages 32-48, March.
  7. Shiller, Robert J, 1979. "The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 87(6), pages 1190-1219, December.
  8. Benjamin M. Friedman, 1985. "Crowding Out or Crowding In? Evidence on Debt-Equity Substitutability," NBER Working Papers 1565, National Bureau of Economic Research, Inc.
  9. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, Econometric Society, vol. 53(2), pages 363-84, March.
  10. Melino, Angelo, 1988. " The Term Structure of Interest Rates: Evidence and Theory," Journal of Economic Surveys, Wiley Blackwell, Wiley Blackwell, vol. 2(4), pages 335-66.
  11. Irwin Friend & Joel Hasbrouck, . "Effect of Inflation on the Profitability and Valuation of U.S. Corporations," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 4-82, Wharton School Rodney L. White Center for Financial Research.
  12. repec:nbr:nberwo:2341 is not listed on IDEAS
  13. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, Elsevier, vol. 7(3), pages 265-296, September.
  14. Roley, V Vance, 1982. "The Effect of Federal Debt-Management Policy on Corporate Bond and Equity Yields," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 97(4), pages 645-68, November.
  15. Modigliani, Franco & Shiller, Robert J, 1973. "Inflation, Rational Expectations and the Term Structure of Interest Rates," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 40(157), pages 12-43, February.
  16. Irwin Friend & Joel Hasbrouck, . "Effect of Inflation on the Profitability and Valuation of U.S. Corporations," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 04-82, Wharton School Rodney L. White Center for Financial Research.
  17. Benjamin M. Friedman, 1978. "Price Inflation, Portfolio Choice, and Nominal Interest Rates," NBER Working Papers 0235, National Bureau of Economic Research, Inc.
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Cited by:
  1. Lopez, Jose A, 2001. "Evaluating the Predictive Accuracy of Volatility Models," Journal of Forecasting, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 20(2), pages 87-109, March.
  2. Kenneth D. West & Hali J. Edison & Dongchul Cho, 1993. "A utility based comparison of some models of exchange rate volatility," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 441, Board of Governors of the Federal Reserve System (U.S.).
  3. Sherrill Shaffer, 1995. "The discount window and credit availability," Working Papers 95-23, Federal Reserve Bank of Philadelphia.
  4. Kenneth Kuttner, 2006. "Can Central Banks Target Bond Prices?," NBER Working Papers 12454, National Bureau of Economic Research, Inc.
  5. D H Kim, 2002. "Another look at yield spreads: The role of liquidity," Centre for Growth and Business Cycle Research Discussion Paper Series, Economics, The Univeristy of Manchester 04, Economics, The Univeristy of Manchester.
  6. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, Elsevier, vol. 52(1-2), pages 5-59.
  7. Tong, Wilson H. S., 1996. "An examination of dynamic hedging," Journal of International Money and Finance, Elsevier, Elsevier, vol. 15(1), pages 19-35, February.
  8. Tim BOLLERSLEV & Ray Y. CHOU & Narayanan JAYARAMAN & Kenneth F. KRONER, 1991. "Les modéles ARCH en finance : un point sur la théorie et les résultats empiriques," Annales d'Economie et de Statistique, ENSAE, ENSAE, issue 24, pages 1-59.
  9. Longin, Francois M, 1997. "The Threshold Effect in Expected Volatility: A Model Based on Asymmetric Information," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 10(3), pages 837-69.
  10. Shaffer, Sherrill, 1998. "Capital Requirements and Rational Discount-Window Borrowing," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 30(4), pages 849-63, November.

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