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Rare Events, Financial Crises, and the Cross-Section of Asset Returns

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  • Bianchi, Francesco

Abstract

This paper shows that rare events are important in explaining the cross section of asset returns because of their role in shaping agents' expectations. I reconsider the "bad beta, good beta" ICAPM proposed by Campbell and Vuolteenaho and I point out that the explanatory power of the model relies on including the stock market crash that opened the Great Depression. When using a Markov-switching VAR, a '30s regime is identified. This regime receives a large weight when forming expectations consistent with the ICAPM, suggesting that the way agents think about financial markets is shaped by what happens during extreme circumstances. From a technical point of view, the paper extends the present value decomposition of Campbell and Shiller to allow for Markov-switching dynamics in the law of motion of the state variables. This approach could shed new light on the sensitivity of the present value decomposition methodology to the sample choice.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 20831.

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Date of creation: 01 Jan 2008
Date of revision: 01 Jan 2010
Handle: RePEc:pra:mprapa:20831

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Keywords: Markov-switching; Rare Events; Bayesian; Asset Pricing;

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  1. Uhlig, Harald, 1999. "What are the Effects of Monetary Policy on Output? Results from an Agnostic Identification Procedure," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2137, C.E.P.R. Discussion Papers.
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  12. Campbell, John, 1991. "A Variance Decomposition for Stock Returns," Scholarly Articles 3207695, Harvard University Department of Economics.
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  16. Chang-Jin Kim & Charles R. Nelson, 1999. "State-Space Models with Regime Switching: Classical and Gibbs-Sampling Approaches with Applications," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262112388, December.
  17. Christopher A. Sims & Tao Zha, 2006. "Were There Regime Switches in U.S. Monetary Policy?," American Economic Review, American Economic Association, American Economic Association, vol. 96(1), pages 54-81, March.
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  19. Christopher A. Sims, 2006. "Rational Inattention: Beyond the Linear-Quadratic Case," American Economic Review, American Economic Association, American Economic Association, vol. 96(2), pages 158-163, May.
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  23. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
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