Title: The Price of Stock and Bond Risk in Recoveries
Abstract: Investor aversion to risk varies over the course of the economic cycle. In the current recovery, the rebound in risk-taking is near the top of the historical range. The pace of economic growth does not appear to explain the increase in risk appetite. However, statistical research suggests that the severity of the preceding recession explains about 20% of the change in a measure of the long-term stock price-earnings ratio. And corporate profit growth appears to explain about 40% of the decline in the spread between risky and risk-free bonds. The current economic recovery has been sluggish compared with past upturns, but the stock market has posted sizable gains. Do higher stock prices mean that investors now have greater appetite for risk? If so, is this greater risk-taking unusual compared with previous economic cycles? This Economic Letter compares investor risk aversion in the current recovery with past recoveries since World War II. The Letter considers the price of risk, that is, the return investors require to take on a given quantity of risk at a particular point in time. It also examines what explains the change in investor risk aversion during the recovery. Asset pricing and the business cycle The expected return for holding a risky financial asset is the sum of the return from a risk-free asset and the premium earned from bearing risk. This risk premium can be broken down into the quantity of risk in an asset multiplied by the price for bearing a given unit of risk. That risk price depends on investors’ level of risk aversion.
Publication Year: 2013
Publication Date: 2013-01-01
Language: en
Type: article
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