The Real Response to Uncertainty Shocks: the Risk Premium Channel

61 Pages Posted: 22 Mar 2017 Last revised: 16 Oct 2019

See all articles by Lorenzo Bretscher

Lorenzo Bretscher

London Business School - Department of Finance

Alex Hsu

Georgia Institute of Technology - Scheller College of Business

Andrea Tamoni

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick

Date Written: March 26, 2019

Abstract

Uncertainty shocks are also risk premium shocks. With countercyclical risk aversion (RA), a positive shock to uncertainty increases risk and elevates RA as consumption growth falls. The combination of high RA and high uncertainty produces significant risk premia in bad times, which in turn exacerbate the decline of macroeconomic aggregates and equity prices. Moreover, uncertainty is a priced risk factor in the cross-section of equity returns only when the factor exposure is a time-varying function of RA. In a model with endogenously time-varying RA, uncertainty produces large falls in investment and equity prices that closely match state-dependent data responses.

Keywords: Risk Aversion, Uncertainty, Conditional IRF, Dynamic Economies

JEL Classification: C32, C63, E32, E44

Suggested Citation

Bretscher, Lorenzo and Hsu, Alex and Tamoni, Andrea, The Real Response to Uncertainty Shocks: the Risk Premium Channel (March 26, 2019). Georgia Tech Scheller College of Business Research Paper No. 17-13. Available at SSRN: https://ssrn.com/abstract=2938361 or http://dx.doi.org/10.2139/ssrn.2938361

Lorenzo Bretscher

London Business School - Department of Finance ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

Alex Hsu

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States
4043851123 (Phone)

Andrea Tamoni (Contact Author)

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick ( email )

1 Washington Park
Newark, NJ 07102
United States

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