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 and Reviews › RGC 21 - Publication in refereed journal › peer-review

28 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. © The Author(s) 2018. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please e-mail: [email protected].

Original language	English
Pages (from-to)	1148-1187
Journal	Review of Financial Studies
Volume	32
Issue number	3
DOIs	https://doi.org/10.1093/rfs/hhy066
Publication status	Published - 1 Mar 2019
Externally published	Yes

Bibliographical note

Publication details (e.g. title, author(s), publication statuses and dates) are captured on an “AS IS” and “AS AVAILABLE” basis at the time of record harvesting from the data source. Suggestions for further amendments or supplementary information can be sent to [email protected].

Funding

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)

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

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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. © The Author(s) 2018. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please e-mail: [email protected].

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. © The Author(s) 2018. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please e-mail: [email protected].

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DO - 10.1093/rfs/hhy066

M3 - RGC 21 - Publication in refereed journal

SN - 0893-9454

VL - 32

SP - 1148

EP - 1187

JO - Review of Financial Studies

JF - Review of Financial Studies

IS - 3

ER -

Macroeconomic Risk and Idiosyncratic Risk-taking

Abstract

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