Implied Risk Premium and the Business Cycle: You Can’t Always Get What You Want
Georg Bestelmeyer (University of Cologne), et al. | December 1, 2011
We analyze the link between investor’s risk premia demands and overall business conditions. In contrast to previous studies we focus on ex-ante risk premia expectations implied in market prices and earnings forecasts rather than ex-post realized excess returns. We find that implied risk premia are counter-cyclical and strongly driven by the economic environment. On average, implied risk premia are higher (lower) when the economy is contracting (expanding). In contrast, realized excess returns on a monthly frequency do not show this pattern over our sample period March 1983 to December 2009. In addition, implied risk premia are highly sensitive to macroeconomic risk factors such as term- and default spreads. Our findings emphasize that implied risk premia are time varying and strongly tied to the business cycle – much more than realized excess returns.