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Asset Pricing in a Production Economy with ChewÐDekel Preferences

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Author Info

  • Claudio Campanale

    ()
    (University of Alicante, Spain)

  • Rui Castro

    ()
    (University of Montreal, Canada)

  • Gian Luca Clementi

    ()
    (New York University, USA and The Rimini Centre for Economic Analysis, Italy)

Abstract

In this paper we provide a thorough characterization of the asset returns implied by a simple general equilibrium production economy with convex investment adjustment costs. When households have EpsteinÐZin preferences, there exist plausible parameter values such that the model generates unconditional mean riskÐfree rate and equity return, and volatility of consumption growth, which are in line with historical averages for the US economy. Consistently with the data, the priceÐdividend ratio is proÐcyclical and stock returns are predictable (and increasingly so as the time horizon increases), while dividend growth is not. The model also implies realistic values for (i) the correlation of the riskÐfree rate with output growth and consumption growth and (ii) the correlation pattern between riskÐfree rate, equity return, and equity premium. The risk implied by the model is rather low. Given the work of Rabin (2000) among others, it is not surprising that our EpsteinÐZin agent exhibits a much higher risk aversion when faced with substantially larger risks. This shortcoming, however, does not extend to the case in which agents are disappointment averse in the sense of Gul (1991). When faced with a lottery that has a coefficient of variation 100 times as large as that implied by our model, a disappointment averse agent displays the same relative risk aversion as an expected utility agent with logarithmic utility!

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Bibliographic Info

Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 07-07.

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Date of creation: Jul 2007
Date of revision: Jul 2007
Handle: RePEc:rim:rimwps:07-07

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Keywords: Equity Premium; Business Cycle; Predictability; Disappointment Aversion;

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References

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  1. Palfrey, Thomas R. & Goeree, Jacob & Holt, Charles, 2000. "Quantal Response Equilibrium and Overbidding in Private-value Auctions," Working Papers 1073, California Institute of Technology, Division of the Humanities and Social Sciences.
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