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Asset pricing with time varying pessimism and rare disasters

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  • Zhang, Jian
  • Kong, Dongmin
  • Liu, Hening
  • Wu, Ji

Abstract

We incorporate time-varying consumption volatility in the representative-agent asset pricing model with generalized recursive smooth ambiguity preferences developed by Ju and Miao (2012). We calibrate the model to data on consumption and asset returns since the Great Depression period. Uncertainty aversion amplifies the perceived probability of the disastrous state coupled with high consumption volatility. We find that the model with time-varying volatility generates a high equity risk premium. When we impose the condition that no consumption disasters ever realized in simulated samples, the model with time-varying volatility can reproduce predictability of returns and non-predictability of consumption growth simultaneously, which are consistent with empirical findings.

Suggested Citation

  • Zhang, Jian & Kong, Dongmin & Liu, Hening & Wu, Ji, 2019. "Asset pricing with time varying pessimism and rare disasters," International Review of Economics & Finance, Elsevier, vol. 60(C), pages 165-175.
    • Handle: RePEc:eee:reveco:v:60:y:2019:i:c:p:165-175
    DOI: 10.1016/j.iref.2018.11.005
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    1. Ruan, Xinfeng, 2021. "Ambiguity, long-run risks, and asset prices in continuous time," International Review of Economics & Finance, Elsevier, vol. 71(C), pages 115-126.

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    More about this item

    Keywords

    Equity premium; Rare disaster; Uncertainty aversion; Volatility risk;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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