The Time Variation in Risk Appetite and Uncertainty

76 Pages Posted: 14 Nov 2017 Last revised: 15 Jul 2019

See all articles by Geert Bekaert

Geert Bekaert

Columbia Business School - Finance and Economics

Eric Engstrom

U.S. Board of Governors of the Federal Reserve System - Division of Research and Statistics, Capital Markets

Nancy R. Xu

Boston College, Carroll School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: July 15, 2019

Abstract

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

Bekaert, Geert and Engstrom, Eric C. and Xu, Nancy R., The Time Variation in Risk Appetite and Uncertainty (July 15, 2019). Columbia Business School Research Paper No. 17-108; 31st Australasian Finance and Banking Conference 2018; American Finance Association Annual Meeting 2019. Available at SSRN: https://ssrn.com/abstract=3069078 or http://dx.doi.org/10.2139/ssrn.3069078

Geert Bekaert

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Eric C. Engstrom

U.S. Board of Governors of the Federal Reserve System - Division of Research and Statistics, Capital Markets ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-3044 (Phone)

Nancy R. Xu (Contact Author)

Boston College, Carroll School of Management ( email )

Carroll School of Management
140 Commonwealth Avenue
Chestnut Hill, MA 02467-3808
United States

HOME PAGE: http://www.nancyxu.net

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