When the Risk Premium Is Negative

57 Pages Posted: 10 Jan 2020 Last revised: 1 Sep 2020

See all articles by Luca Pezzo

Luca Pezzo

University of New Orleans

Yinchu Zhu

University of Oregon

Date Written: August 31, 2020

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

Suggested Citation

Pezzo, Luca and Zhu, Yinchu, When the Risk Premium Is Negative (August 31, 2020). Available at SSRN: https://ssrn.com/abstract=3497848 or http://dx.doi.org/10.2139/ssrn.3497848

Luca Pezzo (Contact Author)

University of New Orleans ( email )

2000 Lakeshore Drive
New Orleans, LA 70148
United States

Yinchu Zhu

University of Oregon ( email )

1280 University of Oregon
Eugene, OR 97403
United States

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