Asset Pricing with the Awareness of New Priced Risks

Abstract

Recessions lead to substantial, yet not immediate drop in output. The low and often negative growth during recessions is typically followed by a steady recovery with abnormally high growth. We propose a theory where a recession is preceded by the introduction of a new risk source. The expected impact on economic growth of this new risk is negative and varies in terms of duration and severity. Consistent with the data, recovery is slow but characterized by higher than average output growth. We show that the expected path of both risk premia and return volatilities are hump-shaped at the start of a recession, that is, risk premia and return volatilities do not immediately rise which is in contrast to most asset-pricing models. We calibrate the model to the average economic recession and recovery and show that it quantitatively matches the unconditional asset pricing moments as well as asset pricing moments during recessions.

Keywords: crisis dynamics, recessions, business cycles, asset pricing, output growth, new priced risk