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Non-Falsified Expectations and General Equilibrium Asset Pricing: The Power of the Peso

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  • Danthine, Jean-Pierre
  • Donaldson, John B

Abstract

We discuss the extent to which the expectation of a rare event, not present in the usual post-war sample data, but not rationally excludable from the set of possibilities – the peso problem – can affect the behaviour of rational agents and the characteristics of market equilibrium. To that end, we describe quantitatively the macroeconomic and financial properties of a standard equilibrium business cycle model, modified to allow for a very small probability of a depression state. We are careful to contrast what would be the stationary probability distribution descriptive of the dynamic rational expectations (RE) equilibrium, from the empirically observed behaviour of the economy under the same RE assumption when the depression does not appear in the sample. The effects of small probability events appear to be especially significant for financial market characteristics. We produce a reasonable model specification, for which both business cycle characteristics and mean financial returns are in accord with US observations. The 6.2% premium is obtained in an economy where agents are only moderately risk averse and where there are no frictions.

Suggested Citation

  • Danthine, Jean-Pierre & Donaldson, John B, 1998. "Non-Falsified Expectations and General Equilibrium Asset Pricing: The Power of the Peso," CEPR Discussion Papers 1819, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:1819
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    Cited by:

    1. Lu Zhang & Howard Kung & Hang Bai, 2013. ""Shooting" the CAPM," 2013 Meeting Papers 905, Society for Economic Dynamics.
    2. G. A. Christodoulakis & E. C. Mamatzakis, 2009. "Assessing the prudence of economic forecasts in the EU," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 24(4), pages 583-606.
    3. Satyajit Chatterjee & Dean Corbae, 2000. "On the welfare gains of reducing the likelihood of economic crises," Working Papers 00-14, Federal Reserve Bank of Philadelphia.
    4. Mertens, Karel, 2007. "The Role of Expectations in Sudden Stops," Working Papers 07-10, Cornell University, Center for Analytic Economics.
    5. Massimo Guidolin, 2006. "High equity premia and crash fears - Rational foundations," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 28(3), pages 693-708, August.
    6. Hang Bai & Kewei Hou & Howard Kung & Lu Zhang, 2015. "The CAPM Strikes Back? An Investment Model with Disasters," NBER Working Papers 21016, National Bureau of Economic Research, Inc.
    7. George M. Constantinides, 2006. "Market Organization And The Prices Of Financial Assets," Manchester School, University of Manchester, vol. 74(s1), pages 1-23, September.
    8. Laurian Lungu & Patrick Minford, 2006. "Explaining The Equity Risk Premium," Manchester School, University of Manchester, vol. 74(6), pages 670-700, December.
    9. Veronesi, Pietro, 2004. "The Peso problem hypothesis and stock market returns," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 707-725, January.
    10. Natalia Gershun, 2004. "Macrodynamic and Financial Effects of a Large-Scale Technology Change," International Journal of Business and Economics, College of Business and College of Finance, Feng Chia University, Taichung, Taiwan, vol. 3(1), pages 67-81, April.
    11. Groth, Charlotta & Zampolli, Fabrizio, 2010. "Macroeconomic stability and the real interest rate: a cross-country analysis," Discussion Papers 30, Monetary Policy Committee Unit, Bank of England.
    12. Satyajit Chatterjee & Dean Corbae, 2003. "On the welfare gains of eliminating a small likelihood of economic crises: A case for stabilization policies?," Working Papers 03-20, Federal Reserve Bank of Philadelphia.
    13. Guidolin, Massimo, 2006. "Pessimistic beliefs under rational learning: Quantitative implications for the equity premium puzzle," Journal of Economics and Business, Elsevier, vol. 58(2), pages 85-118.
    14. Geoffrey J. Warren, 2008. "Implications for Asset Pricing Puzzles of a Roll-over Assumption for the Risk-Free Asset-super-," International Review of Finance, International Review of Finance Ltd., vol. 8(3-4), pages 125-157.

    More about this item

    Keywords

    Asset Pricing; Business Cycle; Equity Premium; Peso Problem; Rational Expectations;

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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