Financial Crises and Risk Premia

Tyler Muir. "Financial Crises and Risk Premia."The Quarterly Journal of Economics" (2017): 765-809.

This paper splits bad economic events into financial crises, recessions, deep recessions, and wars and analyzes data on consumption, dividend yields, stock returns, and credit spreads with an international panel that spans over 140 years across 14 countries. By analyzing this panel data, the paper seeks to answer why do risk premia vary over time, exploring potential underlying economic forces behind the time-varying risk premia.

The occurrence of a financial crisis is based on a major bank run or bank failure, so financial crisis and banking panic are interchangeable in this paper's context. Recession refers to "nonfinancial recessions,"; i.e., recessions that do not coincide with a financial crisis. Deep recessions are defined as nonfinancial recessions for which the initial drop in consumption exceeds 2%. The definition of war is straightforward.

The main proxies for risk premia used in this paper are dividend yields and credit spreads. Previous studies show that dividend yields appear to strongly predict future stock returns and only very weakly forecast future dividend growth. Similarily, fluctuations in credit spreads seem to largely predict excess returns and not default rates (cash flows). These documented stylized facts from previous literature lend support to the use of those two variables as proxies for risk premia, mainly conveying signals related to discount rate news rather than cash flow (related to fundamentals) news.

The main findings of this paper boil down to the figures presented below;

One should note that, as panel B indicates, the decline in consumption and increase in consumption volatility are similar across financial crises and recession or deep recessions, but we can observe a spike in risk premia only for financial crises, not for the other two events. Moreover, war events entail a much higher decline in consumption and an increase in consumption volatility than financial crisis events, but the behavior of risk premia seems not distinctive compared to nonfinancial recessions and deep recessions. In a nutshell, the prices fall for all those types of events, but a considerable degree of the spike in risk premia is only observed during the financial crisis events, making it unique.

The figure below essentially shows the same phenomena discussed above;

As we can clearly observe, the differential behavior of consumption and consumption volatility patterns across each of the different bad macroeconomic events can hardly be reconciled with the evolution of the proxies for risk premia, dividend yields and credit spreads. Here, again, financial crisis events are unique in the sense that only they entail a distinguishably higher level of risk premia compared to the other events relative to the evolutions of consumption behavior and volatilities.mAlso, the figure indicates that financial crises are associated with large price declines that are subsequently reversed, meaning the crisis is largely about a change in discount rates not in fundamentals (cash flows). Overall, the presented results indicate that asset pricing models based on aggregated consumption may have trouble matching the facts provided from the international panel data. In addition, the results imply that financial crises may be particularly important in understanding why risk premia vary.

After presenting the results, the author discusses what type of asset pricing model appears promising to match the data. Obviously, the standard consumption-based models with a representative agent don't seem to fit well. Also, long-run risks model, as well as rare disasters model, seem to have difficulty in explaining the presented facts in the paper. 

Intermediary-based models, in which stochastic discount factor depends on the health of the financial sector, seems promising in the sense that it naturally implies risk premia will be highest in financial crises. In addition, if a behavioral model can successfully exposit why there should be a distinguishably huge drop in investor sentiment that largely or exclusively pertains to financial crises for reasons beyond poor past returns, it may well match the data also. Lastly, the view on heterogeneous agents models is inconclusive in that some models such as models with idiosyncratic income or consumption risk may be linked with the behavior of risk premia during financial crises through the channel of unemployment, which has been uniquely high during the crises relative to the other events.