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Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM

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  • Posch, Olaf
  • Schrimpf, Andreas

Abstract

This paper shows that the consumption-based asset pricing model (C-CAPM) with low-probability disaster risk rationalizes large pricing errors, i.e., Euler equation errors. This result is remarkable, since Lettau and Ludvigson (2009) show that leading asset pricing models cannot explain sizeable pricing errors in the C-CAPM. We also show (analytically and in a Monte Carlo study) that implausible estimates of risk aversion and time preference are not puzzling in this framework and emerge as a result of rational pricing errors. While this bias essentially removes the pricing error in the traditional endowment economy, a production economy with stochastically changing investment opportunities generates large and persistent empirical pricing errors.

Suggested Citation

  • Posch, Olaf & Schrimpf, Andreas, 2013. "Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM," VfS Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 79987, Verein für Socialpolitik / German Economic Association.
  • Handle: RePEc:zbw:vfsc13:79987
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
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    8. Martin Lettau & Sydney Ludvigson, 2001. "Resurrecting the (C)CAPM: A Cross-Sectional Test When Risk Premia Are Time-Varying," Journal of Political Economy, University of Chicago Press, vol. 109(6), pages 1238-1287, December.
    9. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
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    Cited by:

    1. Grammig, Joachim & Sönksen, Jantje, 2014. "Consumption-Based Asset Pricing with Rare Disaster Risk: A Simulated Method of Moments Approach," VfS Annual Conference 2014 (Hamburg): Evidence-based Economic Policy 100614, Verein für Socialpolitik / German Economic Association.
    2. Sönksen, Jantje & Grammig, Joachim, 2020. "Empirical Asset Pricing with Multi-Period Disaster Risk: A Simulation-Based Approach," CFR Working Papers 14-06, University of Cologne, Centre for Financial Research (CFR).
    3. Grammig, Joachim & Sönksen, Jantje, 2014. "Consumption-based asset pricing with rare disaster risk," CFS Working Paper Series 480, Center for Financial Studies (CFS).

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    More about this item

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models

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