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Risk Aversion and Changes in Regime

Author

Listed:
  • Tomas E. Caravello

    (Massachusetts Institute of Technology)

  • John Driffill

    (Yale-NUS)

  • Turalay Kenc

    (University of Cambridge)

  • Martin Sola

    (Universidad Torcuato di Tella)

Abstract

We develop and estimate a consumption-based asset pricing model that assumes recursive utility using historical US financial data, allowing for regime changes, priced regime risk, and intrinsic bubbles. We also estimate several restricted versions which include only a subset of these features. We find that switching risk is an essential component of the equity risk premium, explaining up to fifty percent of it. Furthermore, a model which does not take this into account would overestimate the degree of risk aversion of the public, mistakenly assigning the observed risk premium to high-risk aversion instead of priced regime-switching. Intrinsic bubbles are not crucial in explaining the risk premia, but they substantially improve the model’s fit at the end of the sample.

Suggested Citation

  • Tomas E. Caravello & John Driffill & Turalay Kenc & Martin Sola, 2023. "Risk Aversion and Changes in Regime," Working Papers 237, Red Nacional de Investigadores en Economía (RedNIE).
    • Handle: RePEc:aoz:wpaper:237
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    File URL: https://rednie.eco.unc.edu.ar/files/DT/237.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Equity Risk Premium; Macroeconomic Risk; Stochastic Differential Utility; Markov Chain; Intrinsic Bubbles;
    All these keywords.

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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