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Asset Return Dynamics under Bad Environment Good Environment Fundamentals

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  • Geert Bekaert
  • Eric Engstrom

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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15222.

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Date of creation: Aug 2009
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Handle: RePEc:nbr:nberwo:15222

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  1. John Y. Campbell & Samuel B. Thompson, 2008. "Predicting Excess Stock Returns Out of Sample: Can Anything Beat the Historical Average?," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 21(4), pages 1509-1531, July.
  2. Chernov, Mikhail & Ronald Gallant, A. & Ghysels, Eric & Tauchen, George, 2003. "Alternative models for stock price dynamics," Journal of Econometrics, Elsevier, Elsevier, vol. 116(1-2), pages 225-257.
  3. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 01-90, Wharton School Rodney L. White Center for Financial Research.
  4. Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1990. "Mean Reversion in Equilibrium Asset Prices," American Economic Review, American Economic Association, American Economic Association, vol. 80(3), pages 398-418, June.
  5. Tim Bollerslev & George Tauchen & Hao Zhou, 2009. "Expected Stock Returns and Variance Risk Premia," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 22(11), pages 4463-4492, November.
  6. Bekaert, Geert & Engstrom, Eric & Xing, Yuhang, 2009. "Risk, uncertainty, and asset prices," Journal of Financial Economics, Elsevier, Elsevier, vol. 91(1), pages 59-82, January.
  7. 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, Econometric Society, vol. 57(4), pages 937-69, July.
  8. Backus, David & Chernov, Mikhail & Martin, Ian, 2009. "Disasters implied by equity index options," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7416, C.E.P.R. Discussion Papers.
  9. 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.
  10. Larry G. Epstein & Stanley E. Zin, 1991. "The Independence Axiom and Asset Returns," NBER Technical Working Papers, National Bureau of Economic Research, Inc 0109, National Bureau of Economic Research, Inc.
  11. Bekaert, Geert & Engstrom, Eric & Grenadier, Steve, 2006. "Stock and Bond Returns with Moody Investors," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5951, C.E.P.R. Discussion Papers.
  12. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  13. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  14. Mark Broadie & Mikhail Chernov & Michael Johannes, 2007. "Model Specification and Risk Premia: Evidence from Futures Options," Journal of Finance, American Finance Association, American Finance Association, vol. 62(3), pages 1453-1490, 06.
  15. 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, Society for Financial Studies, vol. 16(1), pages 101-143.
  16. Geert Bekaert & Jun Liu, 1999. "Conditioning Information and Variance Bounds on Pricing Kernels," NBER Working Papers 6880, National Bureau of Economic Research, Inc.
  17. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 107(2), pages 205-251, April.
  18. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  19. 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, Elsevier, vol. 56(3), pages 407-458, June.
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