Sunday, August 10, 2014

Risk premiums and the business cycle

The key to generating returns in the global economic environment is through understanding how risk premium vary across the business cycle. Get the risk premiums right and you will always be tilted in the right direction with portfolio construction. Risk premiums across all asset classes show a pattern that is consistent with the behavior of business cycles.

Expected returns are highest during those periods when risk high during market downturns. Similarly, returns decline at the height of the business cycle. you get  paid to take-on risky assets when the economy looks bad and others are willing to walk away form risk. You don't get paid to take risk when things are good and everyone wants to buy risk assets. Following risk-taking around the business cycle is inherently counter to the view of many. Countercyclical investing is the key to global macro trading.

Modern finance through stochastic discounting models focuses on the risk premium through the covariance between returns and the discount factor. if the covariance is negative, then risk premiums will increase when the discount factor decreases. The discount factor is related to changes in wealth and or consumption. The risk premium goes up for assets that negatively covaries with the marginal utility of consumption. Investors do not like assets that go down when consumption or wealth falls.  Investors want a hedge against falling consumption and will pay up for those types of assets. Risk aversion is also time variant. It increases when consumption falls. Any portfolio should be consistent with the stylized facts of time varying risk premiums.

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