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Risk Aversion and Changes in Regime

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  • Tomás Caravello
  • Turalay Kenc
  • Martín Sola

Abstract

We develop and estimate a consumption-based asset pricing model that assumes recursive utility using historical US financial data, allowing for regime changes, priced regime risk, and intrinsic bubbles. We also estimate several restricted versions which include only a subset of these features. We find that switching risk is an essential component of the equity risk premium, explaining up to fifty percent of it. Furthermore, a model which does not take this into account would overestimate the degree of risk aversion of the public, mistakenly assigning the observed risk premium to highrisk aversion instead of priced regime-switching. Intrinsic bubbles are not crucial in explaining the risk premia, but they substantially improve the model’s fit at the end of the sample.

Suggested Citation

  • Tomás Caravello & Turalay Kenc & Martín Sola, 2021. "Risk Aversion and Changes in Regime," Department of Economics Working Papers 2021_08, Universidad Torcuato Di Tella.
    • Handle: RePEc:udt:wpecon:2021_08
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    References listed on IDEAS

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    More about this item

    Keywords

    Intrinsic Bubbles; Macroeconomic Risk; Stochastic Differential Utility; Markov Chain; Equity Risk Premium.;
    All these keywords.

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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