Title: Asset pricing with endogenous state-dependent aggregate risk aversion
Authors: Rachida Ouysse - University of New South Wales (Australia) [presenting]
Abstract: An economy is studied where the risk aversion is stochastic and beliefs-dependent. We formulate a consumption-based asset pricing model in which aggregate risk aversion is state-dependent (SDRA) in response not only to news about aggregate consumption as in the habit formation model but also to news about a wide range of key economic indicators. The representative consumer forms their beliefs toward risk from information available about a large number of variables that describe the economy. High-dimensionality of the available information is handled using a factor model. We use the generalized method of moments to estimate a nonlinear model that links information about the states of economic booms and busts to the aggregate risk aversion and to the Euler equations of the pricing model. We explore the pricing implications for a certain cross-section of stock returns. The empirical results support the hypothesis that aggregate risk aversion is counter-cyclical and varies with news about the business cycle. We observe volatility clustering of movements of risk aversion around recession periods. In addition to the price of consumption risk associated with consumption risk (as in the standard consumption capital asset pricing model), the induced time variation in risk aversion introduces risk preferences as a new component in the risk premium due to co-variation between aggregate risk aversion and asset returns.