Time-varying ambiguity, credit spreads, and the levered equity premium

Zhan Shi

Journal of Financial Economics, 2019, vol. 134, issue 3, 617-646

Abstract: This paper studies the effects of time-varying Knightian uncertainty (ambiguity) on asset pricing in a Lucas exchange economy. Specifically, it considers a general equilibrium model where an ambiguity-averse agent applies a discount rate that is adjusted not only for the current magnitude of ambiguity but also for the risk associated with its future fluctuations. As such, both the ambiguity level and volatility help to raise the asset premiums and accommodate richer dynamics of asset prices. Based on a novel empirical measure of the ambiguity level, the estimated model can capture the empirical levels of corporate credit spreads and the equity premium while endogenously matching the historical default probability. More importantly, the model-implied credit spread and equity price-dividend ratio perform remarkably in tracking the time variations in their historical counterparts.

Keywords: Ambiguity; Credit spreads; Equity premium (search for similar items in EconPapers)
JEL-codes: E43 E44 G12 G13 G33 (search for similar items in EconPapers)
Date: 2019
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Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:134:y:2019:i:3:p:617-646

DOI: 10.1016/j.jfineco.2019.04.013

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