The Time Variation in Risk Appetite and Uncertainty
American Finance Association Annual Meeting 2019
86 Pages Posted: 14 Nov 2017 Last revised: 14 May 2019
Date Written: February 20, 2019
We develop measures of time-varying risk aversion and economic uncertainty that are calculated from financial variables at high frequencies. To do so, we formulate a dynamic no-arbitrage asset pricing model for equities and corporate bonds. The joint dynamics that we specify among asset-specific cash flows, macroeconomic fundamentals and risk aversion accommodate both heteroskedasticity and non-Gaussianity. 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 our 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