Equilibrium Variance Risk Premium in a Cost-free Production Economy

48 Pages Posted: 10 May 2018 Last revised: 10 Jan 2019

See all articles by Xinfeng Ruan

Xinfeng Ruan

Xi'an Jiaotong-Liverpool University

Jin E. Zhang

University of Otago, Otago Business School, Department of Accountancy and Finance

Date Written: January 5, 2018

Abstract

This paper extends the production-based equilibrium model studied by Zhang, Zhao, and Chang (2012), in which the stock return has constant volatility and the investor has a constant relative risk aversion (CRRA) utility function, into more general settings where the volatility of the stock return is stochastic and with jumps, and the investor has recursive preferences. The recursive preferences help us to separately find that the higher the elasticity of intertemporal substitution (EIS) and the relative risk aversion (RRA), the higher the equity and variance risk premiums. In equilibrium, risk premiums are determined by the diffusive and jump risks from the stock return and its volatility innovation. The empirical analysis documents that the production-based equilibrium model in a cost-free economy can well explain the equity premium puzzle and the term structure of the variance risk premium (VRP). In addition, our equilibrium model also explains the return predictability of VRP.

Keywords: Variance risk premium; term structure; equity premium puzzle; cost-free production economy; affine model.

JEL Classification: G12; G13

Suggested Citation

Ruan, Xinfeng and Zhang, Jin E., Equilibrium Variance Risk Premium in a Cost-free Production Economy (January 5, 2018). Journal of Economic Dynamics and Control, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3168248 or http://dx.doi.org/10.2139/ssrn.3168248

Xinfeng Ruan (Contact Author)

Xi'an Jiaotong-Liverpool University ( email )

111 Renai Road, SIP
, Lake Science and Education Innovation District
Suzhou, JiangSu province 215123
China

Jin E. Zhang

University of Otago, Otago Business School, Department of Accountancy and Finance ( email )

Dunedin, 9054
New Zealand
64 3 479 8575 (Phone)
64 3 479 8171 (Fax)

HOME PAGE: http://sites.google.com/site/jinzhanghomepage/home

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