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Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM

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  • Posch, Olaf
  • Schrimpf, Andreas

Abstract

This paper shows that the consumption-based asset pricing model (C-CAPM) with low-probability disaster risk rationalizes large pricing errors, i.e., Euler equation errors. This result is remarkable, since Lettau and Ludvigson (2009) show that leading asset pricing models cannot explain sizeable pricing errors in the C-CAPM. We also show (analytically and in a Monte Carlo study) that implausible estimates of risk aversion and time preference are not puzzling in this framework and emerge as a result of rational pricing errors. While this bias essentially removes the pricing error in the traditional endowment economy, a production economy with stochastically changing investment opportunities generates large and persistent empirical pricing errors. --

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Paper provided by Verein für Socialpolitik / German Economic Association in its series Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order with number 79987.

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Date of creation: 2013
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Handle: RePEc:zbw:vfsc13:79987

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  1. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  2. Martin Lettau & Sydney Ludvigson, 1999. "Resurrecting the (C)CAPM: a cross-sectional test when risk premia are time-varying," Staff Reports, Federal Reserve Bank of New York 93, Federal Reserve Bank of New York.
  3. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, American Finance Association, vol. 59(4), pages 1481-1509, 08.
  4. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  5. Christian Julliard & Anisha Ghosh, 2008. "Can rare events explain the equity premium puzzle?," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 4808, London School of Economics and Political Science, LSE Library.
  6. Xavier Gabaix, 2008. "Variable Rare Disasters: A Tractable Theory of Ten Puzzles in Macro-finance," American Economic Review, American Economic Association, American Economic Association, vol. 98(2), pages 64-67, May.
  7. Posch, Olaf, 2009. "Structural estimation of jump-diffusion processes in macroeconomics," Journal of Econometrics, Elsevier, Elsevier, vol. 153(2), pages 196-210, December.
  8. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(1), pages 117-131, July.
  9. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, Elsevier, vol. 3(4), pages 373-413, December.
  10. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, Econometric Society, vol. 50(4), pages 1029-54, July.
  11. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  12. Mark Rubinstein, 1976. "The Valuation of Uncertain Income Streams and the Pricing of Options," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 7(2), pages 407-425, Autumn.
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Cited by:
  1. Grammig, Joachim & Sönksen, Jantje, 2014. "Consumption-based asset pricing with rare disaster risk," CFR Working Papers 14-06, University of Cologne, Centre for Financial Research (CFR).

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