exogenous. One is that we can use it to generate realistic levels and time variation in risk premia. In contrast, general equilibrium production models (e.g. Jermann (1998), Boldrin, Christiano, and Fisher (2001), and Kaltenbrunner and Lochstoer (2008)) imply risk premia that are too smooth and possibly procyclical. This is problematic given the strong evidence for substantial and countercyclical variation in risk premia, established in studies such as Fama and Schwert (1977), Keim and Stambaugh (1986), and Fama and French (1989) for equities and by Fama and Bliss (1987) and Campbell and Shiller (1991) for bonds.РThe other advantage is that time-varying risk premia, within an exogenous pricing kernel, can be “turned off” without having to alter any other model assumptions. This allows us to
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