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.Received July 1, 2017; editorial decision January 22, 2018 by Editor Stijn Van Nieuwerburgh. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.