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Can Rare Events Explain the Equity Premium Puzzle?

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  • Anisha Ghosh

    ()

  • Christian Julliard

    ()

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 significantly 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.

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Bibliographic Info

Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp610.

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Date of creation: Apr 2008
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Handle: RePEc:fmg:fmgdps:dp610

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Web page: http://www2.lse.ac.uk/fmg/

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Cited by:
  1. Xavier Gabaix & Samuel Fraiberg & Romain Ranciere & Adrien Verdehlha & Emmanuel Farhi, 2010. "Crash Risk in Currency Market," 2010 Meeting Papers 640, Society for Economic Dynamics.
  2. Gourio, François, 2011. "Credit Risk and Disaster Risk," CEPR Discussion Papers 8201, C.E.P.R. Discussion Papers.
  3. Francisco Peñaranda & Enrique Sentana, 2010. "A Unifying Approach To The Empirical Evaluation Of Asset Pricing Models," Working Papers wp2010_1004, CEMFI.
  4. François Gourio, 2009. "Disasters Risk and Business Cycles," NBER Working Papers 15399, National Bureau of Economic Research, Inc.
  5. Francois Gourio, 2010. "Credit risk and Disaster risk," 2010 Meeting Papers 112, Society for Economic Dynamics.
  6. Lukas Menkhoff & Lucio Sarno & Maik Schmeling & Andreas Schrimpf, 2012. "Carry Trades and Global Foreign Exchange Volatility," Journal of Finance, American Finance Association, vol. 67(2), pages 681-718, 04.
  7. Olaf Posch, 2010. "Risk Premia in General Equilibrium," CESifo Working Paper Series 3131, CESifo Group Munich.
  8. Craig Burnside, 2011. "Carry Trades and Risk," NBER Working Papers 17278, National Bureau of Economic Research, Inc.
  9. Francois Gourio, 2009. "Disaster risk and business cycles," 2009 Meeting Papers 1176, Society for Economic Dynamics.
  10. Francesco Bianchi, 2010. "Rare Events, Financial Crises, and the Cross-Section of Asset Returns," Working Papers 10-40, Duke University, Department of Economics.
  11. François Gourio, 2012. "Macroeconomic implications of time-varying risk premia," Working Paper Series 1463, European Central Bank.
  12. Robert J. Barro & José F. Ursúa, 2012. "Rare Macroeconomic Disasters," Annual Review of Economics, Annual Reviews, vol. 4(1), pages 83-109, 07.
  13. 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, 5.

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