When the Risk Premium Is Negative

Abstract

A recent successful literature derives non-parametric time-varying lower bounds on the risk premia of asset returns in real time. The implicit restriction is that equilibrium risk premia of assets positively correlated with the market must be strictly positive. Such strong requirement is not supported by the data, especially in most recent years, and investors can profit from it. There exist states of the world, identified by recessionary periods and times where consumption and production growth is low and volatility is high, causing the violations of the Euler equations, implying non-monotonic Stochastic Discount Factors and possibly the violation of the no-arbitrage condition for a non-trivial class of models.

Keywords: Risk Premium, Stochastic Discount Factor, Euler equations, Non-parametric test, Bad Times, Market-timing

JEL Classification: C12, C58, G11, G12, G13