A Decomposition of Conditional Risk Premia and Implications for Representative Agent Models

209 Pages Posted: 1 Dec 2020 Last revised: 26 Jun 2023

See all articles by Fousseni Chabi-Yo

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management

Johnathan Loudis

University of Notre Dame - Mendoza College of Business

Date Written: June 22, 2023

Abstract

We develop a methodology to decompose the conditional market risk premium and risk premia on higher-order moments of excess market returns into risk premia related to contingent claims on down, up, and moderate market returns. The decomposition exploits information about the risk-neutral market return distribution embedded in option prices but does not depend on assumptions about the functional form of investor preferences or about the market return distribution. The total market risk premium is highly time-varying, as are the contributions from downside, upside, and central risk. Time series variation in risk premia associated with each region is primarily driven by variation in risk prices associated with the probability of entering each region at short horizons, but it is primarily driven by variation in risk quantities at longer horizons. Analogous decompositions implied by prominent representative agent models generally fail to match the dynamic risk premium behavior implied by the data. Our results provide a set of new empirical facts regarding the drivers of conditional risk premia and identify new challenges for representative agent models.

Keywords: Market risk premium; Variance risk premium; Crash risk; Risk-neutral moments; Preferences; Stochastic Discount Factor

JEL Classification: E44; G1; G12; G13

Suggested Citation

Chabi-Yo, Fousseni and Loudis, Johnathan, A Decomposition of Conditional Risk Premia and Implications for Representative Agent Models (June 22, 2023). Available at SSRN: https://ssrn.com/abstract=3734689 or http://dx.doi.org/10.2139/ssrn.3734689

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States

Johnathan Loudis (Contact Author)

University of Notre Dame - Mendoza College of Business ( email )

Notre Dame, IN 46556-5646
United States

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