Why Do Risk Premia Vary Over Time? A Theoretical Investigation Under Habit Formation
Source: Bank of England
Empirical evidence suggests that risk premia are higher at business cycle troughs than they are at peaks. Existing asset pricing theories ascribe moves in risk premia to changes in volatility or risk aversion. Nevertheless, in a simple general equilibrium model, risk premia can be procyclical even though the volatility of consumption is constant and despite a counter cyclically varying risk aversion coefficient. The authors show that agents' expectations about future prospects also influence premium dynamics. In order to generate counter cyclically varying premia, as found in the data, one requires a combination of hump-shaped consumption dynamics or highly persistent shocks and habits.