The Time Variation in Risk Appetite and Uncertainty
American Finance Association Annual Meeting 2019
76 Pages Posted: 14 Nov 2017 Last revised: 15 Jul 2019
Date Written: July 15, 2019
We formulate a dynamic no-arbitrage asset pricing model for equities and corporate bonds, featuring time-varying risk aversion and economic uncertainty. The joint dynamics that we specify among asset-specific cash flows, macroeconomic fundamentals and risk aversion accommodate both heteroskedasticity and non-Gaussianity. As the main contribution, the model delivers measures of risk aversion and uncertainty at daily frequency. In addition, we find that variance risk premiums on equity are very informative about risk aversion, whereas credit spreads and corporate bond volatility are highly correlated with economic uncertainty. Our model-implied risk premiums outperform standard instruments for predicting excess returns on equity and corporate bonds. A financial proxy to economic uncertainty predicts output growth significantly and negatively.
Keywords: Risk aversion, Economic uncertainty, Dynamic asset pricing model, Asymmetric state variables, VIX, Variance risk premium.
JEL Classification: C1, G10, G12, G13
Suggested Citation: Suggested Citation