Why do Risk Premia Vary over Time? A Theoretical Investigation under Habit Formation

21 Pages Posted: 16 Feb 2009  

Bianca De Paoli

Federal Reserve Bank of New York; London School of Economics & Political Science (LSE) - Centre for Economic Performance (CEP)

Pawel Zabczyk

CCBS, Bank of England

Date Written: February 16, 2009

Abstract

Empirical evidence suggests that risk premia are higher at business cycle troughs than they are at peaks. Existing asset pricing theories ascribe moves in risk premia to changes in volatility or risk aversion. Nevertheless, in a simple general equilibrium model, risk premia can be procyclical even though the volatility of consumption is constant and despite a countercyclically varying risk aversion coefficient. We show that agents' expectations about future prospects also influence premium dynamics. In order to generate countercyclically varying premia, as found in the data, one requires a combination of hump-shaped consumption dynamics or highly persistent shocks and habits. Our results, thus, suggest that factors which help match activity data may also help along the asset pricing dimension.

Suggested Citation

De Paoli, Bianca and Zabczyk, Pawel, Why do Risk Premia Vary over Time? A Theoretical Investigation under Habit Formation (February 16, 2009). Bank of England Working Paper No. 361. Available at SSRN: https://ssrn.com/abstract=1344291 or http://dx.doi.org/10.2139/ssrn.1344291

Bianca De Paoli (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

London School of Economics & Political Science (LSE) - Centre for Economic Performance (CEP) ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Pawel Zabczyk

CCBS, Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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