Risk, Uncertainty and Asset Prices

Abstract

We identify the relative importance of changes in the conditional variance of fundamentals (which we call uncertainty) and changes in risk aversion in the determination of the term structure, equity prices and risk premiums. Theoretically, we introduce persistent time-varying uncertainty about the fundamentals in an external habit model. The model matches the dynamics of dividend and consumption growth, including their volatility dynamics and many salient asset market phenomena. While the variation in price-dividend ratios and the equity risk premium is primarily driven by risk aversion, uncertainty plays a large role in the term structure and is the driver of counter-cyclical volatility of asset returns.

Keywords: Equity Premium, Economic Uncertainty, Stochastic Risk Aversion, Time Variation in Risk and Return, Excess Volatility, External Habit, Term Structure, Heteroskedasticity

JEL Classification: G12, G15, E44