Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM
AbstractThis paper shows that the consumption-based asset pricing model (C-CAPM) with low-probability disaster risk rationalizes large pricing errors, i.e. Euler equation errors. This result is remarkable, since Lettau and Ludvigson (2009) show that leading asset pricing models cannot explain sizeable pricing errors in the C-CAPM. We also show (analytically and in a Monte Carlo study) that implausible estimates of risk aversion and time preference are not puzzling in this framework and emerge as a result of rational pricing errors. While this bias essentially removes the pricing error in the traditional endowment economy, a production economy with stochastically changing investment opportunities generates large and persistent empirical pricing errors.
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Bibliographic InfoPaper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2012-32.
Date of creation: 11 Jul 2012
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Web page: http://www.econ.au.dk/afn/
Euler equation errors; Rare disasters; C-CAPM;
Find related papers by JEL classification:
- E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- O41 - Economic Development, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-07-23 (All new papers)
- NEP-MAC-2012-07-23 (Macroeconomics)
- NEP-UPT-2012-07-23 (Utility Models & Prospect Theory)
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