Macroeconomic Risk Revisited: Term Structure of Risk Premia and Long Run Risk in a Two-State Economy with Epstein-Zin Preferences

Abstract

Under what conditions can the term structure of risk premia be downward sloping, as reported in a number of recent empirical studies? I study fixed income and equity risk premium term structures and the long run risk in a continuous time Lucas-style economy subject to a persistent regime change modelled as a two-state Markov chain with a representative agent having Epstein-Zin-Weil preferences. I derive closed form solutions for the term structures of the risk premia of finite maturity bonds, the equity market and equity dividend strips, as well as the term structure of Sharpe ratio, and clarify under what conditions the risk term structures can be downward sloping. When fitted with historic data for U.S. consumption, this model is capable of generating downward sloping risk premium term structure for the parameters traditionally used in long run risk models.

Keywords: long run risk, risk premium term structure, dividend strips, Epstein-Zin preferences, Markov chains

JEL Classification: G10, G12