On the sources of the aggregate risk premium: Risk aversion, bubbles or regime-switching?

Tomás E. Caravello, John Driffill, Turalay Kenc and Martin Sola

Journal of Economic Dynamics and Control, 2024, vol. 166, issue C

Abstract: We develop and estimate a consumption-based asset pricing model that uses historical US financial data and assumes recursive utility, allowing for priced regime-switching risk and intrinsic bubbles. We also estimate several restricted versions, including only a subset of these features. Priced regime-switching risk is essential to the equity risk premium, explaining more than fifty per cent of it. Furthermore, a model that does not consider regime switching would overestimate the public's risk aversion, mistakenly assigning the observed risk premium to high-risk aversion instead of priced regime-switching. We also find that intrinsic bubbles are statistically significant, and even though they are not crucial in explaining the risk premium, they substantially improve the model's fit at the end of the sample.

Keywords: Equity risk premium; Macroeconomic risk; Stochastic differential utility; Markov chain; Intrinsic bubbles (search for similar items in EconPapers)
JEL-codes: C32 E44 G00 G12 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:166:y:2024:i:c:s0165188924001118

DOI: 10.1016/j.jedc.2024.104919

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