A lot of empirical work has documented stylized facts that suggest links between macroeconomics and finance. As yet there no well developed theory to explain these stylized facts. Standard model fail to reproduce the level, variation, and cyclical co-movement of equity premia. This research investigates several aspects of the relationship between aggregate risk, risk premia, and the pricing of financial assets. Chapter 2 presents new evidence on the level and movements of the expected excess return of stocks, and its relation to sources of macroeconomic risk, from a model that allows time variation in risk premia. The third chapter develops a theory of asset prices based on standard expected utility that explains the links between risk and the empirically-observed high and time-varying risk premia, volatile prices, and predictable excess returns. In contrast to extant literature, we show that it is possible to rationalize major movements in the stock market with standard preferences. Understanding the level and variation of equity premia is crucial to answer Lucas' (1987) question about how costly individuals find business cycle fluctuations in consumption growth. In the final chapter, the results from the previous chapters are applied to address Lucas' question in a model that replicates the level and nature of individual consumption risk, and the Sharpe-ratio of the S&P 500. We find that large welfare gains from stabilization policies are possible.
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