prudential uncertainty causes time-varying risk premiums

Paper (Nov 2012);   Slides

Time-varying risk premiums are a natural consequence of prudent savings behavior. Prudence prescribes a countercyclical marginal propensity to consume which leads to countercyclical consumption volatility and risk premiums. This "prudential uncertainty" channel is amplified by external habit, which makes the investor feel poorer and act more prudently. A calibrated production economy with a slow-moving, external habit shows that this channel can quantitatively explain return and dividend predictability regressions. The model matches numerous other moments, including the mean and volatility of the equity premium, the mean and volatility of the risk-free rate, and the second moments of output, consumption, and investment.



[This figure shows scatterplots from simulations of the calibrated production economy.]