DP5947 Risk, Uncertainty and Asset Prices

Author(s): Geert Bekaert, Eric Engstrom, Yuhang Xing
Publication Date: November 2006
Keyword(s): equity premium, excess volatility, external habit, stochastic risk aversion, term structure, time variation in risk and return, uncertainty
JEL(s): E44, G12, G15
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5947

We identify the relative importance of changes in the conditional variance of fundamentals (which we call "uncertainty") and changes in risk aversion ("risk" for short) in the determination of the term structure, equity prices and risk premiums. Theoretically, we introduce persistent time-varying uncertainty about the fundamentals in an external habit model. The model matches the dynamics of dividend and consumption growth, including their volatility dynamics and many salient asset market phenomena. While the variation in dividend yields and the equity risk premium is primarily driven by risk, uncertainty plays a large role in the term structure and is the driver of counter-cyclical volatility of asset returns.