Risk, Uncertainty and Asset Prices
57 Pages Posted: 3 Jan 2007
Date Written: November 2006
We identify the relative importance of changes in the conditional variance of fundamentals (which we call "uncertainty") and changes in risk aversion ("risk" for short) in the determination of the term structure, equity prices and risk premiums. Theoretically, we introduce persistent time-varying uncertainty about the fundamentals in an external habit model. The model matches the dynamics of dividend and consumption growth, including their volatility dynamics and many salient asset market phenomena. While the variation in dividend yields and the equity risk premium is primarily driven by risk, uncertainty plays a large role in the term structure and is the driver of counter-cyclical volatility of asset returns.
Keywords: Equity premium, uncertainty, stochastic risk aversion, time variation in risk and return, excess volatility, external habit, term structure
JEL Classification: E44, G12, G15
Suggested Citation: Suggested Citation