Time-varying risk aversion and the equity term structure

I show that time-varying risk aversion over wealth can generate a term structure of equity risk premia that is upward sloping in bad times and downward sloping in good times. I thereby provide a mechanism behind recent reduced-form models that successfully match the counter-cyclicality of the equity term structure assuming exogenous stochastic discount factors. The parsimonious model that I propose jointly matches the empirical findings on the conditional equity term structures, cross sectional variation of the equity term structure, return predictability and the idiosyncratic volatility puzzle. I also discuss several new predictions. More broadly, I illustrate the importance of key experimental findings of risk preferences, like being domain-specific, time-varying and allowing risk seekingness, for understanding asset prices.