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Carlstrom and Fuerst meets Epstein and Zin: The Asset Pricing Implications of Contracting Frictions

Author

Listed:
  • Ram Yamarthy

    (University of Pennsylvania)

  • Amir Yaron

    (University of Pennsylvania)

  • Joao Gomes

    (University of Pennsylvania)

Abstract

Models with financial frictions have been shown to create amplification and persistence effects in macroeconomic fluctuations. We test the ability that Costly State Verification (CSV) has to generate empirically plausible risk exposures in asset markets, when Epstein and Zin (1989) preferences are implemented. Under the setup of Carlstrom and Fuerst (1997) alongside recursive preferences, we find that the CSV friction is negligible in augmenting the aggregate equity premium, explaining roughly thirty basis points when monitoring costs are increased. Additionally we find that the separation between the elasticity of intertemporal substitution and risk aversion plays a key role in explaining financial market dynamics. We are only able to generate sizable equity premium when the elasticity is greater than one.

Suggested Citation

  • Ram Yamarthy & Amir Yaron & Joao Gomes, 2015. "Carlstrom and Fuerst meets Epstein and Zin: The Asset Pricing Implications of Contracting Frictions," 2015 Meeting Papers 1267, Society for Economic Dynamics.
    • Handle: RePEc:red:sed015:1267
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    References listed on IDEAS

    as
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    Cited by:

    1. Hengjie Ai & Jun E Li & Kai Li & Christian Schlag, 2020. "The Collateralizability Premium," The Review of Financial Studies, Society for Financial Studies, vol. 33(12), pages 5821-5855.
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    3. Schumacher, Malte D. & Żochowski, Dawid, 2017. "The risk premium channel and long-term growth," Working Paper Series 2114, European Central Bank.
    4. Ai, Hengjie & Li, Kai & Yang, Fang, 2020. "Financial intermediation and capital reallocation," Journal of Financial Economics, Elsevier, vol. 138(3), pages 663-686.
    5. Hu, Weiwei & Li, Kai & Xu, Yiming, 2023. "Leasing and the allocation efficiency of finance," Journal of Empirical Finance, Elsevier, vol. 74(C).

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