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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

Related research

Keywords: Rare events Jumps Disasters Equity premium Return predictability;

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References

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  1. Jacob Boudoukh & Matthew Richardson & Robert F. Whitelaw, 2008. "The Myth of Long-Horizon Predictability," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1577-1605, July.
  2. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
  3. Jessica Wachter, 2008. "Can time-varying risk of rare disasters explain aggregate stock market volatility?," 2008 Meeting Papers 944, Society for Economic Dynamics.
  4. Amit Goyal & Ivo Welch, 2004. "A Comprehensive Look at the Empirical Performance of Equity Premium Prediction," Yale School of Management Working Papers amz2412, Yale School of Management, revised 01 Jan 2006.
  5. Robert F. Stambaugh, 1999. "Predictive Regressions," NBER Technical Working Papers 0240, National Bureau of Economic Research, Inc.
  6. Francis Longstaff & Monika Piazzesi, 2003. "Corporate Earnings and the Equity Premium," NBER Working Papers 10054, National Bureau of Economic Research, Inc.
  7. Campbell, John, 1996. "Understanding Risk and Return," Scholarly Articles 3153293, Harvard University Department of Economics.
  8. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  9. Francois Gourio, 2008. "Disasters and Recoveries," American Economic Review, American Economic Association, vol. 98(2), pages 68-73, May.
  10. Xavier Gabaix, 2007. "Linearity-Generating Processes: A Modelling Tool Yielding Closed Forms for Asset Prices," NBER Working Papers 13430, National Bureau of Economic Research, Inc.
  11. Xavier Gabaix, 2008. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," NBER Working Papers 13724, National Bureau of Economic Research, Inc.
  12. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  13. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  14. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
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Citations

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Cited by:
  1. Volker Wieland & Christos Koulovatianos, 2011. "Asset Pricing under Rational Learning about Rare Disasters," 2011 Meeting Papers 1417, Society for Economic Dynamics.
  2. François Gourio, 2013. "Credit Risk and Disaster Risk," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 1-34, July.
  3. 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.
  4. Kelly, Bryan & Lustig, Hanno & van Nieuwerburgh, Stijn, 2012. "Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees," CEPR Discussion Papers 9023, C.E.P.R. Discussion Papers.
  5. 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.
  6. 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.
  7. Dolmas, Jim, 2013. "Disastrous disappointments: asset-pricing with disaster risk and disappointment aversion," Working Papers 1309, Federal Reserve Bank of Dallas.
  8. Jessica Wachter, 2008. "Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?," NBER Working Papers 14386, National Bureau of Economic Research, Inc.
  9. Jerry Tsai, 2013. "Rare Disasters and the Term Structure of Interest Rates," Economics Series Working Papers 665, University of Oxford, Department of Economics.
  10. François Gourio, 2009. "Disasters Risk and Business Cycles," NBER Working Papers 15399, National Bureau of Economic Research, Inc.
  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. 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.
  13. Gourio, François, 2012. "Macroeconomic implications of time-varying risk premia," Working Paper Series 1463, European Central Bank.

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