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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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References

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  1. Mikhail Chernov & A. Ronald Gallant & Eric Ghysels & George Tauchen, 2002. "Alternative Models for Stock Price Dynamics," CIRANO Working Papers 2002s-58, CIRANO.
  2. 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.
  3. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  4. Tim Bollerslev & Hao Zhou, 2006. "Expected stock returns and variance risk premia," Finance and Economics Discussion Series 2007-11, Board of Governors of the Federal Reserve System (U.S.).
  5. 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.
  6. 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.
  7. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08.
  8. Bekaert, Geert & Engstrom, Eric & Xing, Yuhang, 2009. "Risk, uncertainty, and asset prices," Journal of Financial Economics, Elsevier, vol. 91(1), pages 59-82, January.
  9. Bekaert, Geert & Engstrom, Eric & Grenadier, Steven R., 2010. "Stock and bond returns with Moody Investors," Journal of Empirical Finance, Elsevier, vol. 17(5), pages 867-894, December.
  10. 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.
  11. 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.
  12. Geert Bekaert & Jun Liu, 1999. "Conditioning Information and Variance Bounds on Pricing Kernels," NBER Working Papers 6880, National Bureau of Economic Research, Inc.
  13. David Backus & Mikhail Chernov & Ian Martin, 2009. "Disasters Implied by Equity Index Options," Working Papers 09-14, New York University, Leonard N. Stern School of Business, Department of Economics.
  14. Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Mark, 1988. "Mean Reversion in Equilibrium Asset Prices," NBER Working Papers 2762, National Bureau of Economic Research, Inc.
  15. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  16. Epstein, Larry G. & Zin, Stanley E., 2001. "The independence axiom and asset returns," Journal of Empirical Finance, Elsevier, vol. 8(5), pages 537-572, December.
  17. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  18. 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, vol. 107(2), pages 205-251, April.
  19. 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.
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Citations

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Cited by:
  1. 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.
  2. 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.
  3. Ivan Shaliastovich & George Tauchen, 2009. "Pricing of the Time-Change Risks," Working Papers 10-71, Duke University, Department of Economics.
  4. Bekaert, Geert & Hodrick, Robert J & Zhang, Xiaoyan, 2010. "Aggregate Idiosyncratic Volatility," CEPR Discussion Papers 8149, C.E.P.R. Discussion Papers.
  5. Philippe Mueller & Andrea Vedolin & Hao Zhou, 2011. "Short Run Bond Risk Premia," FMG Discussion Papers dp686, Financial Markets Group.
  6. Bekaert, Geert & Hoerova, Marie & Lo Duca, Marco, 2013. "Risk, uncertainty and monetary policy," Journal of Monetary Economics, Elsevier, vol. 60(7), pages 771-788.
  7. Jianjian Jin, 2013. "Jump-Diffusion Long-Run Risks Models, Variance Risk Premium and Volatility Dynamics," Working Papers 13-12, Bank of Canada.
  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. 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.
  10. 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.).
  11. Gianluca Benigno & Pierpaolo Benigno & Salvatore Nistic�, 2012. "Risk, Monetary Policy, and the Exchange Rate," NBER Macroeconomics Annual, University of Chicago Press, vol. 26(1), pages 247 - 309.
  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. 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.

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