Fundamental Sources of the Time Variation in Equity Risk Levels

Abstract

I propose an asset-pricing model with preference shocks and contemporaneous cash-flow risk that can explain key asset-pricing patterns related to business cycle. In this consumption-based model with preference shocks, contemporaneous cash-flow risk of equities drives the cross section of risk premia in bad times, i.e. during periods with a high recession probability, relatively more than in good times. This model makes new predictions about the conditional relevance of cash flow risk for asset prices that are confirmed in data. Unlike in models with external habits or long-run risks, a model with preference shocks correlated with business-cycle shocks further implies that reasonable quantities of contemporaneous cash-flow risk have a significant effect on conditional risk premia of assets and return volatility.