Tail Risk and Equity Risk Premia

This paper develops a new semi-parametric estimation method based on an extended ICAPM dynamic model incorporating jump tails. Themodel allows for time-varying, asymmetric jumpsizedistributions and a self-exciting jump intensity process while avoiding commonly used but restrictive affine assumptions on the relationship between jump intensity andvolatility. The estimatedmodel implies that the average annual jump risk premium is 6.75%. Themodel-implied jump risk premium also has strong explanatory power for short-to-medium run aggregate market returns. Empirically, I present new estimates of the model based equity risk premia of so-called ”Small-Big”, ”Value-Growth” and ”Winners-Losers” portfolios. Further, I find that they are all time-varying and all crashed in the 2008 financial crisis. Additionally, both the jump and volatility components of equity risk premia are especially important for the ”Winners-Losers” portfolio. ∗I benefited from discussions with my advisors Tim Bollerslev, George Tauchen, Hao Zhou, and Andrew Patton. I am also grateful for comments from Jia Li, Viktor Todorov and doctoral students in the Duke Financial Econometrics lunch group. All errors are my own. For an updated version of this paper, please check my personal website http://laixu.me. †Department of Economics, Duke University, Durham NC 27708 USA, Email [email protected], Phone 919-257-0059.