Investor risk premia and real macroeconomic fluctuations

The premium for risk should have a significant impact on real economic activity: basic finance teaches corporate managers to evaluate new investment opportunities based on a risk-adjusted cost of capital. Moreover, many asset pricing models show this premium should vary with economic conditions. Firms seeking to invest in the midst of a recession when the premium for risk is high, for example, must offer a higher rate of return on new investments. By inducing changes in investment, the risk premium should affect new durable orders, employment, and other measures of economic performance. We measure the risk premia implied by the Fama-French (Fama, E.F., French, K.R., 1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 25, 3-56) asset pricing model and test whether innovations in the premia are informative about future real economic activity. Our results indicate that these shocks, especially those to the premium related to small firms, induce responses in the real economy similar to those from monetary policy disturbances.