Abstract
Time-varying risk aversion is the economic mechanism underlying several recent theoretical models that appear to match important features of equity return data at the market level. In this paper, we estimate a time-varying risk-return relation using only market level data that allows for feedback from both news about volatility and news about risk-aversion. Allowing for feedback effects dramatically improves our ability to explain variation in returns, and the estimated model exhibits statistically and economically significant variation in the price of risk. Consistent with theoretical intuition, the price of risk varies counter-cyclically, with risk aversion increasing substantially over the course of economic contractions. Interestingly, it is variation in the price of risk, not in the quantity of risk, that is the dominant component of the equity risk premium. This phenomenon may partially account for the puzzling results that often arise in estimating models with an assumed constant price of risk.
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