Fundamental Sources of the Time Variation in Equity Risk Levels

Abstract

What drives the time variation in equity risk? I find that industries with high fundamental
cash-flow risk have a higher degree of time variation in excess returns, systematic risk premia
and risk-adjusted returns. I propose an asset-pricing model with agents exposed to preference
shocks that can explain key asset-pricing patterns related to business cycle. My work suggests
that, unlike a habit-formation model, a consumption-based model with preference shocks is
useful in determining how cash-flow risk drives the crossectional variation in the empirical
distribution of risk and returns observed across US industries.

Keywords: cash-flow risk, time-varying equity risk, preference shocks, consumption-based asset pricing

JEL Classification: G12