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Time-series predictability in the disaster model

  • Gourio, François

This paper studies whether the Rietz-Barro "disaster" model, extended for a time-varying probability of disaster, can match the empirical evidence on predictability of stock returns. It is shown that when utility is CRRA, the model cannot replicate this evidence, regardless of parameter values. This motivates extending the disaster model to allow for Epstein-Zin utility. Analytical results show that when the probability of disaster is i.i.d., the model with Epstein-Zin utility can match the evidence on predictability qualitatively if the intertemporal elasticity of substitution is greater than unity. The case of a persistent probability of disaster is studied numerically, with partial success.

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Article provided by Elsevier in its journal Finance Research Letters.

Volume (Year): 5 (2008)
Issue (Month): 4 (December)
Pages: 191-203

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Handle: RePEc:eee:finlet:v:5:y:2008:i:4:p:191-203
Contact details of provider: Web page: http://www.elsevier.com/locate/frl

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  1. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  2. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
  3. Xavier Gabaix, 2007. "Linearity-Generating Processes: A Modelling Tool Yielding Closed Forms for Asset Prices," NBER Working Papers 13430, National Bureau of Economic Research, Inc.
  4. Campbell, John, 1996. "Understanding Risk and Return," Scholarly Articles 3153293, Harvard University Department of Economics.
  5. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  6. Amit Goyal & Ivo Welch, 2004. "A Comprehensive Look at the Empirical Performance of Equity Premium Prediction," Yale School of Management Working Papers amz2412, Yale School of Management, revised 01 Jan 2006.
  7. Jessica Wachter, 2008. "Can time-varying risk of rare disasters explain aggregate stock market volatility?," 2008 Meeting Papers 944, Society for Economic Dynamics.
  8. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  9. Francis Longstaff & Monika Piazzesi, 2003. "Corporate Earnings and the Equity Premium," NBER Working Papers 10054, National Bureau of Economic Research, Inc.
  10. Stambaugh, Robert F., 1999. "Predictive regressions," Journal of Financial Economics, Elsevier, vol. 54(3), pages 375-421, December.
  11. Jacob Boudoukh & Matthew Richardson & Robert F. Whitelaw, 2008. "The Myth of Long-Horizon Predictability," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1577-1605, July.
  12. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  13. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  14. Francois Gourio, 2008. "Disasters and Recoveries," American Economic Review, American Economic Association, vol. 98(2), pages 68-73, May.
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