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Time-series predictability in the disaster model

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Author Info
François Gourio () (Boston University, Department of Economics)
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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Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Working Papers Series with number wp2008-016.

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Length: 13
Date of creation: Jan 2008
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Handle: RePEc:bos:wpaper:wp2008-016

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Related research
Keywords: Rare events; Jumps; Disasters; Equity premium; Return predictability;

Find related papers by JEL classification:
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July. [Downloadable!] (restricted)
  2. Longstaff, Francis A. & Piazzesi, Monika, 2004. "Corporate earnings and the equity premium," Journal of Financial Economics, Elsevier, vol. 74(3), pages 401-421, December. [Downloadable!] (restricted)
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  3. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
  4. Robert F. Stambaugh, 1999. "Predictive Regressions," NBER Technical Working Papers 0240, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. 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. [Downloadable!] (restricted)
  6. Jacob Boudoukh & Matthew Richardson & Robert F. Whitelaw, 2008. "The Myth of Long-Horizon Predictability," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 21(4), pages 1577-1605, July. [Downloadable!] (restricted)
  7. Campbell, John Y, 1996. "Understanding Risk and Return," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 298-345, April. [Downloadable!] (restricted)
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  8. Ivo Welch & Amit Goyal, 2008. "A Comprehensive Look at The Empirical Performance of Equity Premium Prediction," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 21(4), pages 1455-1508, July. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. François Gourio, 2009. "Disasters Risk and Business Cycles," NBER Working Papers 15399, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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