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Too Good to Be True: Asset Pricing Implications of Pessimism

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  • Beker, Pablo F

    (Department of Economics, University of Warwick)

  • Espino, Emilio

    (Universidad Torcuato Di Tella)

Abstract

We evaluate whether the introduction of pessimistic homogeneous beliefs in the frictionless Lucas-Mehra-Prescott model and the Kehoe-Levine-Alvarez-Jermann model with endogenous borrowing constraints, helps explain the equity premium, the risk-free rate and the equity volatility puzzles as well as the short-term momentum and long-term reversal of excess returns. We calibrate the model to U.S. data as in Alvarez and Jermann [4] and we find that the data does not contradict the qualitative predictions of the models. When the preferences parameters are disciplined to match both the average annual risk-free rate and equity premium, the Lucas-Mehra-Prescott model gives a more quantitatively accurate explanation for short-term momentum than the Kehoe-Levine-Alvarez-Jermann model but the latter gives a more quantitatively accurate explanation for the equity volatility puzzle. Long-term reversal remains quantitatively unexplained in both models. JEL classification: Financial Markets Anomalies ; Pessimism ; Homogeneous Beliefs ; Limited Enforceability ; Endogenously Incomplete Markets.

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Paper provided by University of Warwick, Department of Economics in its series The Warwick Economics Research Paper Series (TWERPS) with number 1031.

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Date of creation: 2013
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Handle: RePEc:wrk:warwec:1031

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  1. Viktor Tsyrennikov, 2012. "Heterogeneous Beliefs, Wealth Distribution, and Asset Markets with Risk of Default," American Economic Review, American Economic Association, American Economic Association, vol. 102(3), pages 156-60, May.
  2. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, Econometric Society, vol. 46(6), pages 1429-45, November.
  3. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 24(3), pages 401-421, November.
  4. Kocherlakota, Narayana R., 1990. "On the 'discount' factor in growth economies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 25(1), pages 43-47, January.
  5. Gaetano Bloise & Pietro Reichlin & Mario Tirelli, 2013. "Fragility of Competitive Equilibrium with Risk of Default," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 16(2), pages 271-295, April.
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Cited by:
  1. Chien, YiLi & Cole, Harold L. & Lustig, Hanno, 2014. "Implications of heterogeneity in preferences, beliefs and asset trading technologies for the macroeconomy," Working Papers, Federal Reserve Bank of St. Louis 2014-14, Federal Reserve Bank of St. Louis.
  2. YiLi Chien & Harold L. Cole & Hanno Lustig, 2014. "Implications of Heterogeneity in Preferences, Beliefs and Asset Trading Technologies for the Macroeconomy," NBER Working Papers 20328, National Bureau of Economic Research, Inc.

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