- | Wednesday, October 31
- 12:00 PM
- Kaiserplatz 7-9, 4th floor, Room 4.006
The Time Varying Risk Puzzle
Discount rates are not an important driver of financial volatility. I reach this conclusion using a new historical dataset of returns, cashflows and valuations of all major risky asset classes – equity, housing and corporate bonds – across 17 countries from 1870 to today. Variation in discount rates is common to all risky assets: if discount rates are low, prices of equity, housing and corporate bonds should all be high. But this commonality or co-movement is absent in the data: the correlation between discount rate proxies for different asset classes is roughly equal to zero. This stylised fact is confirmed by running return predictability regressions: while asset valuations and macro-financial factors predict returns on individual asset classes, none of these variables predict returns on all three risky assets. The “time varying risk” puzzle of low co-movement poses a challenge to models which attribute financial volatility to variation in the aggregate price of risk. Variation in asset-specific risk, investor heterogeneity and market segmentation all show limited power in explaining the puzzle. Instead, the data point to volatile expectations as the most likely explanation. This expectation volatility also has real effects, with elevated sentiment in housing or corporate bond markets followed by low GDP growth.