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Time-series predictability in the disaster model

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  • Gourio, François

Abstract

This paper studies whether the Rietz-Barro "disaster" model, extended for a time-varying probability of disaster, can match the empirical evidence on predictability of stock returns. It is shown that when utility is CRRA, the model cannot replicate this evidence, regardless of parameter values. This motivates extending the disaster model to allow for Epstein-Zin utility. Analytical results show that when the probability of disaster is i.i.d., the model with Epstein-Zin utility can match the evidence on predictability qualitatively if the intertemporal elasticity of substitution is greater than unity. The case of a persistent probability of disaster is studied numerically, with partial success.

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Bibliographic Info

Article provided by Elsevier in its journal Finance Research Letters.

Volume (Year): 5 (2008)
Issue (Month): 4 (December)
Pages: 191-203

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Handle: RePEc:eee:finlet:v:5:y:2008:i:4:p:191-203

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Web page: http://www.elsevier.com/locate/frl

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Keywords: Rare events Jumps Disasters Equity premium Return predictability;

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References

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  1. Robert F. Stambaugh, 1999. "Predictive Regressions," NBER Technical Working Papers 0240, National Bureau of Economic Research, Inc.
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  7. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  8. Francois Gourio, 2008. "Disasters and Recoveries," American Economic Review, American Economic Association, vol. 98(2), pages 68-73, May.
  9. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
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Cited by:
  1. Max Gillman & Michal Kejak & Michal Pakos, 2014. "Learning about Rare Disasters: Implications for Consumptions and Asset Prices," CEU Working Papers 2014_2, Department of Economics, Central European University.
  2. Francois Gourio, 2012. "Credit risk and disaster risk," Working Paper Series WP-2012-07, Federal Reserve Bank of Chicago.
  3. Jerry Tsai & Jessica A. Wachter, 2014. "Rare Booms and Disasters in a Multi-sector Endowment Economy," NBER Working Papers 20062, National Bureau of Economic Research, Inc.
  4. Dolmas, Jim, 2013. "Disastrous disappointments: asset-pricing with disaster risk and disappointment aversion," Working Papers 1309, Federal Reserve Bank of Dallas.
  5. Stijn Van Nieuwerburgh & Hanno Lustig & Bryan Kelly, 2011. "Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees," 2011 Meeting Papers 1285, Society for Economic Dynamics.
  6. Jessica Wachter, 2008. "Can time-varying risk of rare disasters explain aggregate stock market volatility?," 2008 Meeting Papers 944, Society for Economic Dynamics.
  7. Francois Gourio, 2009. "Disaster risk and business cycles," 2009 Meeting Papers 1176, Society for Economic Dynamics.
  8. Gourio, François, 2012. "Macroeconomic implications of time-varying risk premia," Working Paper Series 1463, European Central Bank.
  9. Koulovatianos, Christos & Wieland, Volker, 2011. "Asset Pricing under Rational Learning about Rare Disasters," CEPR Discussion Papers 8514, C.E.P.R. Discussion Papers.
  10. Jerry Tsai, 2013. "Rare Disasters and the Term Structure of Interest Rates," Economics Series Working Papers 665, University of Oxford, Department of Economics.
  11. Priyank Gandhi & Hanno Lustig, 2010. "Size Anomalies in U.S. Bank Stock Returns: A Fiscal Explanation," NBER Working Papers 16553, National Bureau of Economic Research, Inc.
  12. Berkman, Henk & Jacobsen, Ben & Lee, John B., 2011. "Time-varying rare disaster risk and stock returns," Journal of Financial Economics, Elsevier, vol. 101(2), pages 313-332, August.
  13. Max Gillman & Michal Kejak & Michal Pakos, 2014. "Learning about Disaster Risk: Joint Implications for Consumption and Asset Prices," CERGE-EI Working Papers wp507, The Center for Economic Research and Graduate Education - Economic Institute, Prague.

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