Generalized Risk Premia
53 Pages Posted: 14 Dec 2012 Last revised: 14 Jul 2014
Date Written: December 12, 2012
This paper develops an optimal trading strategy explicitly linked to an agent's preferences and assessment of the distribution of asset returns. The price of this strategy is a portfolio of implied moments, and its expected excess returns naturally accommodate compensation for higher-order moment risk. Variance risk and the equity premium approximate it to first order and it nests cross-sectional asset pricing models such as the CAPM. An empirical study in the US index market compares the investment behavior of an agent with recursive long-run risk preferences to one who merely uses an i.i.d. time series model and takes market prices as given. The two agents exhibit very similar behavior during crises and can be distinguished mostly during calm periods.
Keywords: Predictability, pricing kernel, model risk, trading strategy, model-free, variance premium, skew premium, kurtosispremium
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