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

  • De Paoli, Bianca
  • Zabczyk, Pawel

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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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. Rudebusch, Glenn D. & Swanson, Eric T., 2008. "Examining the bond premium puzzle with a DSGE model," Journal of Monetary Economics, Elsevier, vol. 55(Supplemen), pages S111-S126, October.
  2. Bianca De Paoli & Alasdair Scott & Olaf Weeken, 2006. "Asset pricing implications of a New Keynesian model," Computing in Economics and Finance 2006 358, Society for Computational Economics.
  3. 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.
  4. Lustig, H. & Verdelhan, A., 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Working papers 155, Banque de France.
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