The Term Structure of Risk Premia with Heterogeneous Recursive Preferences and Beliefs
92 Pages Posted: 17 Dec 2017
Date Written: December 7, 2017
Abstract
I investigate the effect of preference and belief heterogeneity on the term structure of risk premia in a continuous-time time economy with Epstein-Zin-Weil preferences. The slope of the term structure of equity risk premia is driven by heterogeneity in the agents' own prices of risk and the sensitivity of the equity market valuation to the changes in economic conditions. As a result, the slope can switch its sign in response to a significant shock to the aggregate consumption. Significant negative shocks shift the consumption and wealth toward the more "pessimistic" agent i.e. the agent with a higher risk aversion or more pessimistic beliefs. As a result, the equity market valuation changes from being pro-cyclical to counter-cyclical, which inverts the term structure. Thus, the model can generate a switch in the sign of the slope of the term structure of the dividend strip risk premia after the 2008-2009 global financial crisis, a result consistent with recent empirical studies and my own calibration based on a proprietary dataset of dividend swap prices.
Keywords: term structure of risk premia, heterogeneity in preferences and beliefs, Epstein-Zin preferences, wealth-consumption ratio, dividend strips
JEL Classification: G01, G11, G12
Suggested Citation: Suggested Citation