Learning about the persistence of recessions under ambiguity aversion

The equity premium increased greatly in the Great Recession and the COVID-19 recession. To explain the magnitude of the increase, this paper proposes a theoretical model where the representative investor is ambiguity averse towards the uncertainty over the persistence of recessions. Results show that ambiguity aversion, as opposed to risk aversion, is the key ingredient to match the sharp increase in the equity premium. Specifically, the effect of ambiguity aversion on the equity premium is asymmetric across economic expansions and recessions. By contrast, an increase in risk aversion results in weaker countercyclical variation in the equity premium.