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Time-varying ambiguity, credit spreads, and the levered equity premium

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  • Shi, Zhan

Abstract

This paper studies the effects of time-varying Knightian uncertainty (ambiguity) on asset pricing in a Lucas exchange economy. Specifically, it considers a general equilibrium model where an ambiguity-averse agent applies a discount rate that is adjusted not only for the current magnitude of ambiguity but also for the risk associated with its future fluctuations. As such, both the ambiguity level and volatility help to raise the asset premiums and accommodate richer dynamics of asset prices. Based on a novel empirical measure of the ambiguity level, the estimated model can capture the empirical levels of corporate credit spreads and the equity premium while endogenously matching the historical default probability. More importantly, the model-implied credit spread and equity price-dividend ratio perform remarkably in tracking the time variations in their historical counterparts.

Suggested Citation

  • Shi, Zhan, 2019. "Time-varying ambiguity, credit spreads, and the levered equity premium," Journal of Financial Economics, Elsevier, vol. 134(3), pages 617-646.
  • Handle: RePEc:eee:jfinec:v:134:y:2019:i:3:p:617-646
    DOI: 10.1016/j.jfineco.2019.04.013
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    More about this item

    Keywords

    Ambiguity; Credit spreads; Equity premium;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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