Countercyclical and Time-Varying Risk Aversion and the Equity Premium

Abstract

This paper tests the counter-cyclicality of aggregate risk aversion and price of market risk using a novel testing approach introduced in Antell and Vaihekoski (2015) for conditional asset pricing models. Cohen et al. (2015) report experimental evidence that the risk aversion is countercyclical, although empirical support from financial studies is at best inconclusive. This paper applies the new testing approach for the Merton (1973, 1980) model with time-varying risk aversion. The testable implications link realized equity premium to, among others, changes in conditional variance, its long-term persistence, and changes in the time-varying risk aversion. Empirically, testing is conducted using monthly US stock market data from 1928 to 2013, and using (asymmetric) GARCH models to estimate conditional variance. We compare various methods to model economic expectations regarding the state of the economy. Unlike the traditional estimation approach, the results from the new estimation approach give support for time-varying and countercyclical behavior for the risk aversion.