Advanced Search
MyIDEAS: Login to save this paper or follow this series

Can rare events explain the equity premium puzzle?

Contents:

Author Info

  • Christian Julliard
  • Anisha Ghosh
Registered author(s):

    Abstract

    Probably not. First, allowing the probabilities attached to the states of the economy to differ from their sample frequencies, the Consumption-CAPM is still rejected by the data and requires a very high level of Relative Risk Aversion(RRA) in order to rationalize the stock market risk premium. This result holds for a variety of data sources and samples –including ones starting as far back as 1890. Second, we elicit the likelihood of observing an Equity Premium Puzzle (EPP) if the data were generated by the rare events probability distribution needed to rationalize the puzzle with a low level of RRA. We find that the historically observed EPP would be very unlikely to arise. Third, we find that the rare events explanation of the EPP signi…cantly worsens the ability of the Consumption-CAPM to explain the cross-section of asset returns. This is due to the fact that, by assigning higher probabilities to bad –economy wide –states in which consumption growth is low and all the assets in the cross-section tend to yield low returns, the rare events hypothesis reduces the cross-sectional dis-persion of consumption risk relative to the cross-sectional variation of average returns

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://eprints.lse.ac.uk/4808/
    File Function: Open access version.
    Download Restriction: no

    Bibliographic Info

    Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 4808.

    as in new window
    Length: 50 pages
    Date of creation: Mar 2008
    Date of revision:
    Handle: RePEc:ehl:lserod:4808

    Contact details of provider:
    Postal: LSE Library Portugal Street London, WC2A 2HD, U.K.
    Phone: +44 (020) 7405 7686
    Web page: http://www.lse.ac.uk/
    More information through EDIRC

    Related research

    Keywords: Rare events; Rare disasters; Equity premium puzzle; Generalized empirical likelihood; Semi-parametric Bayesian inference; Calibration; Cross-section of asset;

    Find related papers by JEL classification:

    References

    References listed on IDEAS
    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.:
    as in new window
    1. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, vol. 36, pages 394.
    2. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
    3. Naoto Kunitomo & Yukitoshi Matsushita, 2003. "On Finite Sample Distributions of the Empirical Likelihood Estimator and the GMM Estimator," CIRJE F-Series CIRJE-F-200, CIRJE, Faculty of Economics, University of Tokyo.
    4. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    5. Copeland, Laurence & Zhu, Yanhui, 2007. "Rare Disasters and the Equity Premium in a Two-Country World," Cardiff Economics Working Papers E2007/6, Cardiff University, Cardiff Business School, Economics Section.
    6. Saikkonen, Pentti & Ripatti, Antti, 2000. "On the Estimation of Euler Equations in the Presence of a Potential Regime Shift," Manchester School, University of Manchester, vol. 68(0), pages 92-121, Supplemen.
    7. Mark Rubinstein, 1976. "The Valuation of Uncertain Income Streams and the Pricing of Options," Bell Journal of Economics, The RAND Corporation, vol. 7(2), pages 407-425, Autumn.
    8. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
    9. Lopes, Paula & Michaelides, Alexander, 2007. "Rare events and annuity market participation," Finance Research Letters, Elsevier, vol. 4(2), pages 82-91, June.
    10. Stutzer, Michael, 1996. " A Simple Nonparametric Approach to Derivative Security Valuation," Journal of Finance, American Finance Association, vol. 51(5), pages 1633-52, December.
    11. Susanne M. Schennach, 2005. "Bayesian exponentially tilted empirical likelihood," Biometrika, Biometrika Trust, vol. 92(1), pages 31-46, March.
    12. Campbell, John, 1996. "Understanding Risk and Return," Scholarly Articles 3153293, Harvard University Department of Economics.
    13. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
    14. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
    15. Veronesi, Pietro, 2004. "The Peso problem hypothesis and stock market returns," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 707-725, January.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as in new window

    Cited by:
    1. Posch, Olaf & Schrimpf, Andreas, 2013. "Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 79987, Verein für Socialpolitik / German Economic Association.
    2. Gregorio Impavido & Esperanza Lasagabaster & Manuel Garcia-Huitron, 2010. "New Policies for Mandatory Defined Contribution Pensions : Industrial Organization Models and Investment Products," World Bank Publications, The World Bank, number 2462.
    3. Francois Gourio, 2011. "Credit Risk and Disaster Risk," NBER Working Papers 17026, National Bureau of Economic Research, Inc.
    4. Francois Gourio, 2012. "Disaster Risk and Business Cycles," American Economic Review, American Economic Association, vol. 102(6), pages 2734-66, October.
    5. Emmanuel Farhi & Samuel Paul Fraiberger & Xavier Gabaix & Romain Ranciere & Adrien Verdelhan, 2009. "Crash Risk in Currency Markets," NBER Working Papers 15062, National Bureau of Economic Research, Inc.
    6. Gourio, François, 2012. "Macroeconomic implications of time-varying risk premia," Working Paper Series 1463, European Central Bank.

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:ehl:lserod:4808. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Lucy Ayre).

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.