Time-varying state variable risk premia in an ICAPM
We find that the relation between state variables, such as the t-bill rate and term spread, and consumption growth is time-varying. Cross-sectional risk premia for these state variables vary over time accordingly. When a state variable predicts consumption growth strongly relative to its own history, its risk premium increases by 5% (annualized). This effect is magnified by time-variation in the variance of state variables. These two common drivers of time-variation in risk premia are consistent with the conditional implications of the Intertemporal CAPM. Benchmark factors, such as SMB and HML, contain the same conditional expected return effects as the state variable risk premia. Our evidence contributes to recent literature on the unconditional pricing of state variable risk that finds mixed results.