Expected Risk Premium Dynamics Across the Business Cycle and the Stock Market’s Response to Macroeconomic News

Abstract

We examine the short-run impact of macroeconomic announcements on expected – rather than realized – risk-premia, employing individual analysts’ earnings forecasts and an implied cost-of-capital technique based on Gebhardt, Lee, and Swaminathan (2001). We find that during recessions good economic news provide relief for investors, decreasing risk-premia which are on average elevated during economic downturns. On the other hand, in an expansion better than expected news is taken as a signal of overheating, causing investors to increase their on average lower risk-premia demands. No such asymmetries are observed for the other main drivers of stock prices, i.e. risk-free rates and expected earnings: both rise after good news, irrespective of the state of the economy. These findings emphasize the importance of the economic state for expected risk-premia. For example, the short-run pattern documented by Boyd, Jagganthan and Hu (2005), that the overall stock market reacts asymmetrically and state dependently to economic news is explained exclusively by the asymmetric risk-premia response. Moreover, our findings contribute to the literature on countercyclical behavior of realized risk-premia across the business cycle. These studies emphasize the strong predictive power of low frequency macroeconomic data for future realized excess stock market returns (e.g., Lettau and Ludvigson (2001) and Campbell and Diebold (2009)). With respect to the average level of risk-premia, our results are largely in line. However, our finding that the average level and the short-term reaction of expected risk-premia are strongly state dependent calls for the inclusion of macroeconomic state variables when modeling asset prices and estimating market risk-premia.