55 Pages Posted: 20 Apr 2017 Last revised: 22 Jul 2017
Date Written: July 22, 2017
I investigate how levered balance sheets amplify the effects of exogenous aggregate volatility shocks on asset prices. I develop a general equilibrium model with heterogeneous agents, subject to both macro-volatility and standard cash flow shocks. The risk premium is decomposed into exogenous and endogenous volatility components. The former is dictated by time-varying fundamentals, the latter by the strength of the levered agents' balance sheets. I quantify these fluctuations over the business cycle and find that balance sheets play a significant role in amplifying macro-volatility shocks: they produce 6 times more volatile premiums than an economy where only cash-flow shocks are amplified; and on average, 20% of the equity risk premium can be attributed to fluctuations in levered balance sheets. I extend the analysis to a production economy and find quantitatively similar results for asset prices, whereas effects on quantities are mild.
Keywords: Time-varying risk premia, leverage, balance sheet dynamics, risk-sharing
JEL Classification: E44, G11, G12, G20
Suggested Citation: Suggested Citation
Schneider, Andrés, Endogenous and Exogenous Risk Premia (July 22, 2017). Available at SSRN: https://ssrn.com/abstract=2954831