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

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 Economy107, 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.