Why Do Discount Rates Vary?

We argue that in a general equilibrium model, increases in equity risk premia represent “bad” news to investors because they reveal increases in marginal utility. We employ a new empirical methodology and find that the price of “discount rate” risk is negative in the data, contrary to prior research. Our approach relies on using future realized market returns to consistently estimate covariances of asset returns with the market risk premium. Covariances drive observed cross-sectional patterns in the expected returns of stocks and bonds. Ignoring the “risk-premium” factor causes drastic underestimation of the equilibrium price of “level” risk in bond returns.