Equilibrium variance risk premium in a cost-free production economy

Abstract

This paper extends the production-based equilibrium model studied by Zhang et al. (2012), in which the stock return has constant volatility and the investor has a constant relative risk aversion (CRRA) utility function, into more general settings where the volatility of the stock return is stochastic and with jumps, and the investor has recursive preferences. The recursive preferences help us to separately find that the higher the elasticity of intertemporal substitution (EIS) and the relative risk aversion (RRA), the higher the equity and variance risk premiums. In equilibrium, risk premiums are determined by the diffusive and jump risks from the stock return and its volatility innovation. The empirical analysis documents that the production-based equilibrium model in a cost-free economy can explain well the equity premium puzzle and the term structure of the variance risk premium (VRP). In addition, our equilibrium model also explains the return predictability of VRP.