Risk Aversion and Changes in Regime

Tomás Caravello (), Turalay Kenc () and Martín Sola ()

Department of Economics Working Papers from 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 highrisk 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.

Keywords: Intrinsic Bubbles; Macroeconomic Risk; Stochastic Differential Utility,Markov Chain; Equity Risk Premium. (search for similar items in EconPapers)
JEL-codes: C32 E44 G00 G12 (search for similar items in EconPapers)
Pages: 55 pages
Date: 2021-12
New Economics Papers: this item is included in nep-mac, nep-ore, nep-rmg and nep-upt
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https://www.utdt.edu/download.php?fname=_164330683990218500.pdf (application/pdf)

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Working Paper: Risk Aversion and Changes in Regime (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:udt:wpecon:2021_08

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