Endogenous and Exogenous Risk Premia

I investigate how levered balance sheets amplify the effects of exogenous aggregate volatility shocks on asset prices. Risk premia are determined by the interaction of exogenous time-varying fundamentals with the endogenously determined levered balance sheets. When macro-volatility shocks hit the economy, asset prices decline, levered agent loses relatively more net worth and aggregate risk aversion rises endogenously. I find that this feedback between balance sheets and macro-volatility produces six times more volatile premiums than an economy with only cash flow shocks, thus improving the model's ability to match the data. However, the effects on investment and growth are mild.