Macroeconomic Risk and Idiosyncratic Risk-taking

Zhiyao CHEN; Ilya A. STREBULAEV

doi:10.1093/rfs/hhy066

Macroeconomic Risk and Idiosyncratic Risk-taking

Zhiyao CHEN, Ilya A. STREBULAEV^*

^*Corresponding author for this work

Research output: Journal Publications › Journal Article (refereed) › peer-review

11 Citations (Scopus)

Abstract

We develop and estimate a dynamic model of risk-shifting over the business cycle. First, equity holders with Epstein-Zin preferences increase their taking of idiosyncratic risk substantially more than the standard model in repeated games, because they perceive the arrival probability of bad states to be higher than the actual probability and prefer an early resolution of macroeconomic uncertainty. Second, sudden switches to bad states and large shocks in the bad states induce the countercyclical and “synchronized” idiosyncratic risk. Third, combined with the high market risk premium in the bad states, clustered risk-taking generates a countercyclical idiosyncratic volatility discount on equity returns.

Original language	English
Pages (from-to)	1148-1187
Number of pages	40
Journal	Review of Financial Studies
Volume	32
Issue number	3
Early online date	8 Jun 2018
DOIs	https://doi.org/10.1093/rfs/hhy066
Publication status	Published - Mar 2019
Externally published	Yes

Bibliographical note

We thank the editor, Stijn Van Nieuwerburgh, and two anonymous referees for constructive suggestions, Erik Loualiche, Jun Li and participants of 2018 AFA meetings for helpful comments. We also thank Yi Hu for excellent research assistance. Zhiyao Chen acknowledges financial support from the General Research Fund by the Hong Kong Research Grants Council (project 14519816). All errors remain our own. Supplementary data can be found on The Review of Financial Studies Web site.

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10.1093/rfs/hhy066

Cite this

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title = "Macroeconomic Risk and Idiosyncratic Risk-taking",

abstract = "We develop and estimate a dynamic model of risk-shifting over the business cycle. First, equity holders with Epstein-Zin preferences increase their taking of idiosyncratic risk substantially more than the standard model in repeated games, because they perceive the arrival probability of bad states to be higher than the actual probability and prefer an early resolution of macroeconomic uncertainty. Second, sudden switches to bad states and large shocks in the bad states induce the countercyclical and “synchronized” idiosyncratic risk. Third, combined with the high market risk premium in the bad states, clustered risk-taking generates a countercyclical idiosyncratic volatility discount on equity returns.",

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N2 - We develop and estimate a dynamic model of risk-shifting over the business cycle. First, equity holders with Epstein-Zin preferences increase their taking of idiosyncratic risk substantially more than the standard model in repeated games, because they perceive the arrival probability of bad states to be higher than the actual probability and prefer an early resolution of macroeconomic uncertainty. Second, sudden switches to bad states and large shocks in the bad states induce the countercyclical and “synchronized” idiosyncratic risk. Third, combined with the high market risk premium in the bad states, clustered risk-taking generates a countercyclical idiosyncratic volatility discount on equity returns.

AB - We develop and estimate a dynamic model of risk-shifting over the business cycle. First, equity holders with Epstein-Zin preferences increase their taking of idiosyncratic risk substantially more than the standard model in repeated games, because they perceive the arrival probability of bad states to be higher than the actual probability and prefer an early resolution of macroeconomic uncertainty. Second, sudden switches to bad states and large shocks in the bad states induce the countercyclical and “synchronized” idiosyncratic risk. Third, combined with the high market risk premium in the bad states, clustered risk-taking generates a countercyclical idiosyncratic volatility discount on equity returns.

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Macroeconomic Risk and Idiosyncratic Risk-taking

Abstract

Bibliographical note

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