Macroeconomic Dynamics

Articles

WHY DO RISK PREMIA VARY OVER TIME? A THEORETICAL INVESTIGATION UNDER HABIT FORMATION

Bianca De Paolia1 c1 and Pawel Zabczyka2

a1 Centre for Economic Performance London School of Economics and Bank of England

a2 European Central Bank and Bank of England

Abstract

We study the dynamics of risk premia in a model with external habit formation and highlight the significance of “recession predictability”. Although under the specification of Campbell and Cochrane, [Journal of Political Economy 107, 205–251 (1999)] the equity risk premium is countercyclical because increases in risk aversion are reinforced by rising recession risks, this need not be the case more generally. We show analytically that in endowment economies procyclical recession expectations can outweigh countercyclical changes in risk aversion, generating counterfactual risk-premium behavior. However, allowing shocks or habits to be sufficiently persistent, or explicitly accounting for the impact of habits on consumption, suffices to generate countercyclical recession risks and risk premia.

Keywords:

  • Risk Premium;
  • Habits;
  • Countercyclicality;
  • Macrofinance

Correspondence:

c1 Address correspondence to: Bianca De Paoli, Monetary Analysis HO-2, Bank of England, Threadneedle St., London EC2R 8AH, UK; e-mail: bianca.depaoli@bankofengland.co.uk.

Footnotes

The views expressed here do not necessarily represent those of the Bank of England or the Monetary Policy Committee. For helpful comments and suggestions, we would like to thank Andy Blake, John Campbell, Francesco Caselli, Christian Julliard, Thomas Laubach, Alex Michaelides, Jens Søndergaard, Steffen Sørensen, Silvana Tenreyro, Luis Viceira, Olaf Weeken, Peter Westaway, Alwyn Young, and seminar/conference participants at the London School of Economics, 2007 Royal Economic Society conference, 2008 Money and Macro Finance conference, 3rd Dynare conference, First International Symposium in Computational Economics and Finance, and the Bank of England Chief Economists' workshop. All remaining errors are ours.

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