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Overextrapolation of disaster probabilities and asset pricing in a production economy

Author

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  • Gao, Han
  • Lin, Chunpeng
  • Peng, Juan
  • Zhao, Siqi

Abstract

In this paper, the overextrapolation belief about the jump intensity of disaster risk is incorporated into an equilibrium asset pricing model in a production economy. The theoretical results, which are dependent on the level of the jump intensity, show that overextrapolation may induce over/underinvestment and under/overconsumption. Moreover, it is predicted that the overextrapolative agent will always overreact on investment and consumption, which results in higher volatility in the economy and generates a higher equity risk premium under the equilibrium model. However, the effects of overextrapolation on the interest rate are ambiguous. Finally, we find that the overextrapolative agent suffers significant welfare loss due to the distortion of investment and consumption, especially when the jump intensity is far from the long-run mean.

Suggested Citation

  • Gao, Han & Lin, Chunpeng & Peng, Juan & Zhao, Siqi, 2024. "Overextrapolation of disaster probabilities and asset pricing in a production economy," International Review of Economics & Finance, Elsevier, vol. 89(PA), pages 845-854.
    • Handle: RePEc:eee:reveco:v:89:y:2024:i:pa:p:845-854
    DOI: 10.1016/j.iref.2023.07.078
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    More about this item

    Keywords

    Overextrapolation; Disaster probabilities; Investment; Asset pricing; Welfare loss;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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