Ability, Market Volatility, and Heterogeneity in Risk Aversion

Abstract

This study provides empirical evidence that changes to the distribution of ability of economic agents in stock markets (`ability risk') are priced. The finding that the price of ability risk varies countercyclically, in relation to the price of market volatility risk, shows ability risk is not another proxy for market volatility risk. Prior to this study, all attempts at generation of countercyclical relations between risk aversion and equity risk premiums are domiciled in context of economy-wide business cycles. This study is first to generate countercyclical relations between risk aversion and equity risk premiums using, in entirety, parameters of stock markets.

Keywords: Hedging, Countercyclical, Equity Risk Premium, Price of Risk

JEL Classification: G11