Suppose that as the economy moves through a business cycle, risk premiums also change. For example, in a recession when people are concerned about their jobs, risk tolerance might be lower and risk premiums might be higher. In a booming economy, tolerance for risk might be higher and premiums lower.
a. Would a predictably shifting risk premium such as described here be a violation of the efficient market hypothesis?
b. How might a cycle of increasing and decreasing risk premiums create an appearance that stock prices “overreact,” first falling excessively and then seeming to recover?