Christian Skov Jensen, Bocconi University (Job Market Seminar)

"The Cyclicality of Risk and Risk Premia"

Abstract

We consider and reexamine the properties of the market risk premium and variance over the business cycle. While it is well known that the risk premium and variance both increase in recessions, we find that the risk premium is less strongly countercyclical than conditional variance. The ratio of risk premium to variance is therefore weakly procyclical, unlike the Sharpe ratio. We document this fact in a broad global equity sample using a range of methods to time portfolio formation after the onset of a recession. We also provide supporting evidence from option markets. We show that the ratio of risk premium to variance pins down the conditional beta in a regression of the stochastic discount factor on the market return, and its cyclicality helps explain stylized facts about the equity term structure.

Contact person: Peter Norman Sørensen