Working Paper: CEPR ID: DP5947
Authors: Geert Bekaert; Eric Engstrom; Yuhang Xing
Abstract: 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; excess volatility; external habit; stochastic risk aversion; term structure; time variation in risk and return; uncertainty
JEL Codes: E44; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| changes in the conditional variance of fundamentals (uncertainty) (D89) | asset prices (G19) |
| changes in risk aversion (risk) (D81) | asset prices (G19) |
| changes in uncertainty (D89) | equity risk premiums (G12) |
| changes in risk aversion (D11) | equity risk premiums (G12) |
| changes in uncertainty (D89) | term structure (E43) |
| changes in risk aversion (D11) | term structure (E43) |
| uncertainty (D89) | level and slope of the term structure (E43) |
| risk aversion (D81) | level of asset prices (G19) |
| increased uncertainty (D89) | counter-cyclical volatility of asset returns (E32) |
| uncertainty (D89) | asset pricing (G19) |
| changes in risk (D81) | asset prices (G19) |