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Asset Return Dynamics Under Bad Environment-Good Environment Fundamentals

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  • Bekaert, Geert
  • Engstrom, Eric

Abstract

We introduce a "bad environment-good environment" technology for consumption growth in a consumption-based asset pricing model. Using the preference structure from Campbell and Cochrane (1999), the model generates realistic time-varying volatility, skewness and kurtosis in fundamentals while still permitting closed-form solutions for asset prices. The model not only fits standard salient asset prices features including means and volatilities for equity returns and risk free rates, but also generates a realistic variance premium and option prices.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8150.

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Date of creation: Dec 2010
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Handle: RePEc:cpr:ceprdp:8150

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Related research

Keywords: countercyclical risk aversion; dividend yield; economic uncertainty; equity premium; return predictability; variance premium;

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References

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  1. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  2. Mikhail Chernov & A. Ronald Gallant & Eric Ghysels & George Tauchen, 2002. "Alternative Models for Stock Price Dynamics," CIRANO Working Papers 2002s-58, CIRANO.
  3. David Backus & Mikhail Chernov & Ian Martin, 2009. "Disasters implied by equity index options," NBER Working Papers 15240, National Bureau of Economic Research, Inc.
  4. Campbell, John & Thompson, Samuel P., 2008. "Predicting Excess Stock Returns Out of Sample: Can Anything Beat the Historical Average?," Scholarly Articles 2622619, Harvard University Department of Economics.
  5. Tim Bollerslev & Hao Zhou, 2007. "Expected Stock Returns and Variance Risk Premia," CREATES Research Papers 2007-17, School of Economics and Management, University of Aarhus.
  6. Geert Bekaert & Jun Liu, 1999. "Conditioning Information and Variance Bounds on Pricing Kernels," NBER Working Papers 6880, National Bureau of Economic Research, Inc.
  7. Bekaert, Geert & Engstrom, Eric & Grenadier, Steve, 2006. "Stock and Bond Returns with Moody Investors," CEPR Discussion Papers 5951, C.E.P.R. Discussion Papers.
  8. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  9. Gurdip Bakshi & Nikunj Kapadia & Dilip Madan, 2003. "Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 101-143.
  10. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  11. Bekaert, Geert & Engstrom, Eric & Xing, Yuhang, 2009. "Risk, uncertainty, and asset prices," Journal of Financial Economics, Elsevier, vol. 91(1), pages 59-82, January.
  12. Larry G. Epstein & Stanley E. Zin, 1991. "The Independence Axiom and Asset Returns," NBER Technical Working Papers 0109, National Bureau of Economic Research, Inc.
  13. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 01-90, Wharton School Rodney L. White Center for Financial Research.
  14. Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1990. "Mean Reversion in Equilibrium Asset Prices," American Economic Review, American Economic Association, vol. 80(3), pages 398-418, June.
  15. Chernov, Mikhail & Ghysels, Eric, 2000. "A study towards a unified approach to the joint estimation of objective and risk neutral measures for the purpose of options valuation," Journal of Financial Economics, Elsevier, vol. 56(3), pages 407-458, June.
  16. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  17. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  18. Mark Broadie & Mikhail Chernov & Michael Johannes, 2007. "Model Specification and Risk Premia: Evidence from Futures Options," Journal of Finance, American Finance Association, vol. 62(3), pages 1453-1490, 06.
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Citations

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Cited by:
  1. Bekaert, Geert & Hoerova, Marie & Lo Duca, Marco, 2013. "Risk, uncertainty and monetary policy," Journal of Monetary Economics, Elsevier, vol. 60(7), pages 771-788.
  2. Bakshi, Gurdip & Chabi-Yo, Fousseni, 2011. "Variance Bounds on the Permanent and Transitory Components of Stochastic Discount Factors," Working Paper Series 2011-11, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  3. David Backus & Mikhail Chernov & Stanley E. Zin, 2011. "Sources of Entropy in Representative Agent Models," NBER Working Papers 17219, National Bureau of Economic Research, Inc.
  4. Gianluca Benigno & Pierpaolo Benigno & Salvatore Nisticò, 2011. "Risk, Monetary Policy and the Exchange Rate," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 247-309 National Bureau of Economic Research, Inc.
  5. Henkel, Sam James & Martin, J. Spencer & Nardari, Federico, 2011. "Time-varying short-horizon predictability," Journal of Financial Economics, Elsevier, vol. 99(3), pages 560-580, March.
  6. Juan M. Londono, 2011. "The variance risk premium around the world," International Finance Discussion Papers 1035, Board of Governors of the Federal Reserve System (U.S.).
  7. Geert Bekaert & Robert J. Hodrick & Xiaoyan Zhang, 2010. "Aggregate Idiosyncratic Volatility," NBER Working Papers 16058, National Bureau of Economic Research, Inc.
  8. Ravi Jagannathan & Srikant Marakani, 2011. "Price Dividend Ratio Factors : Proxies for Long Run Risk," NBER Working Papers 17484, National Bureau of Economic Research, Inc.
  9. Philippe Mueller & Andrea Vedolin & Hao Zhou, 2011. "Short Run Bond Risk Premia," FMG Discussion Papers dp686, Financial Markets Group.
  10. Anthony W. Lynch & Oliver Randall, 2011. "Why Surplus Consumption in the Habit Model May be Less Persistent than You Think," NBER Working Papers 16950, National Bureau of Economic Research, Inc.
  11. Jianjian Jin, 2013. "Jump-Diffusion Long-Run Risks Models, Variance Risk Premium and Volatility Dynamics," Working Papers 13-12, Bank of Canada.
  12. Brière, Marie & Signori, Ombretta, 2013. "Hedging inflation risk in a developing economy: The case of Brazil," Research in International Business and Finance, Elsevier, vol. 27(1), pages 209-222.
  13. Shaliastovich, Ivan & Tauchen, George, 2011. "Pricing of the time-change risks," Journal of Economic Dynamics and Control, Elsevier, vol. 35(6), pages 843-858, June.

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