Financial Contagion Risk and the Stochastic Discount Factor
89 Pages Posted: 21 Mar 2014 Last revised: 1 Mar 2017
Date Written: November 15, 2016
I provide evidence that financial contagion risk is an important source of the equity risk premium. Banks' contributions to aggregate financial contagion are estimated in a state space framework and linked to systemic risk. Greater bank connectedness today leads to increased systemic risk 3-12 months later. More contagious banks earn significantly greater risk-adjusted returns than less contagious ones and the tradable high contagion-minus-low contagion bank portfolio is priced in the cross-section of stock returns. Stocks that co-move more strongly with contagious banks have greater expected returns. These results are robust to factor model specification, test assets, and time period considered.
Keywords: Asset pricing, Equity risk premium, Financial contagion, State-space modeling, Systemic risk
JEL Classification: C58, G12, G14, G21
Suggested Citation: Suggested Citation