The Time Variation in Risk Appetite and Uncertainty
American Finance Association Annual Meeting 2019
67 Pages Posted: 14 Nov 2017 Last revised: 14 Feb 2020
Date Written: February 12, 2020
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 cash flows, macroeconomic fundamentals and risk aversion accommodate both heteroskedasticity and non-Gaussianity. The model delivers measures of risk aversion and uncertainty at the daily frequency. In addition, we find that equity variance risk premiums 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 asset excess returns.
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