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15
Variable Rare Disasters: An Exactly Solved Framework for
 Ten Puzzles in Macro Finance, Working Paper, NYU
, 2009
"... This article incorporates a timevarying severity of disasters into the hy ..."
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Cited by 160 (11 self)
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This article incorporates a timevarying severity of disasters into the hy
Learning about Consumption Dynamics
, 2010
"... This paper studies the asset pricing implications of Bayesian learning about the parameters, states, and models determining aggregate consumption dynamics. Our approach is empirical and focuses on the quantitative implications of learning in realtime using post World War II consumption data. We cha ..."
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Cited by 8 (0 self)
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This paper studies the asset pricing implications of Bayesian learning about the parameters, states, and models determining aggregate consumption dynamics. Our approach is empirical and focuses on the quantitative implications of learning in realtime using post World War II consumption data. We characterize this learning process and provide empirical evidence that revisions in beliefs stemming from parameter and model uncertainty are signi…cantly related to realized aggregate equity returns. Further, we show that beliefs regarding the conditional moments of consumption growth are strongly timevarying and exhibit business cycle and/or longrun ‡uctuations. Much of the longrun behavior is unanticipated ex ante. We embed these subjective beliefs in a general equilibrium model and …nd that about half of the post WorldWar II observed equity market risk premium and much of the observed return predictability are due to unexpected revisions in beliefs about parameters and models governing consumption dynamics.
Rare Events, Financial Crises, and the CrossSection of Asset Returns
, 2008
"... This paper shows that rare events are useful in explaining the cross section of asset returns because they are important in shaping agentsexpectations. I reconsider the "bad beta, good beta " ICAPM and I point out that the explanatory power of the model depends on including the stock marke ..."
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Cited by 4 (1 self)
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This paper shows that rare events are useful in explaining the cross section of asset returns because they are important in shaping agentsexpectations. I reconsider the "bad beta, good beta " ICAPM and I point out that the explanatory power of the model depends on including the stock market crash that opened the Great Depression. When using a Markovswitching VAR, a 30s regime is identi
ed. This regime receives a large weight when forming expectations consistent with the ICAPM. I then generalize this result showing that
nancial variables behave in a substantially di¤erent way during a crisis. Accordingly, the ICAPM delivers excellent results when investors distinguish between a high and a lowuncertainty regime. As a technical contribution, I describe how to estimate a Markovswitching VAR in reduced form. I am grateful to Chris Sims for useful suggestions at the early stage of this work. I thank Robert Barro,
Disaster Risk and its Implications for Asset Pricing
 NBER Working Papers 20926, National Bureau of Economic Research, Inc
, 2015
"... After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premi ..."
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Cited by 1 (0 self)
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After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing, and the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.
International Asset Pricing with Risk Sensitive Rare Events
"... We propose a frictionless general equilibrium model in which two international consumers with recursive preferences trade two consumption goods and a complete set of date and state contingent securities. Consumption home bias and concern for the temporal distribution of risk generate rich dynamics f ..."
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Cited by 1 (0 self)
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We propose a frictionless general equilibrium model in which two international consumers with recursive preferences trade two consumption goods and a complete set of date and state contingent securities. Consumption home bias and concern for the temporal distribution of risk generate rich dynamics for international prices and quantities. In our model, exchange rate movements are as volatile as they are in the data. Furthermore, both the volatility of the exchange rate movements and riskpremia are endogenously time varying and history dependent.
Heterogeneous Beliefs about Rare Event Risk in the Lucas
, 2013
"... This paper investigates the asset pricing implications of investor disagreement about the likelihood of a systemic disaster. I specify a general equilibrium Lucas endowment economy with multiple trees and heterogeneous beliefs about the risk of rare systemic events; the aim is to understand how risk ..."
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This paper investigates the asset pricing implications of investor disagreement about the likelihood of a systemic disaster. I specify a general equilibrium Lucas endowment economy with multiple trees and heterogeneous beliefs about the risk of rare systemic events; the aim is to understand how risksharing mechanisms and fear affect equity and variance risk premia, at an aggregate level and in the cross section of stock returns. I first identify a statedependent conditional link between equity and variance premia, that changes with the crosssectional distribution of agent consumption. Second, although the riskneutral stock returns correlation is increasing in the share of pessimistic agents, the correlation computed under the objective measure is not; the result is a countercyclical correlation risk premium. Third, as the number of assets increases, the aggregate variance premium is driven almost entirely by fear of systemic disasters. Empirically, I find that, as anticipated by the model, the variance premium’s power to predict future excess returns is greater during times of financial distress, which typically feature more disagreement among investors. This result holds especially for
1 An Extension of the Dynamic Model
, 2015
"... Our model presented in the paper captures a number of the key features we have found in the data. In particular, the model captures the fact that when equilibrium public buying is low, risk premia may be high as this may correspond to time when dealers are (or act as if they are) more risk averse. H ..."
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Our model presented in the paper captures a number of the key features we have found in the data. In particular, the model captures the fact that when equilibrium public buying is low, risk premia may be high as this may correspond to time when dealers are (or act as if they are) more risk averse. However, as in Chen, Joslin, and Tran (2012), wealth moves slowly between the public sector and dealers outside of disasters and only through crash insurance premiums. In this section, we generalize our main model to account for more general time variation in the relative wealth of the public and dealers. Consider the case where the public and dealer not only view the disaster events differently, but also disagree about the future path of the likelihood of disasters. Specifically, consider the more general form of Equation (A9) where dPD dPP = ρNte(1−ρ) ∫ t 0 λsds × e− ∫ s 0 θsdW λ s − ∫ t 0 θ
Volatility of Volatility and Tail Risk Premiums
, 2013
"... NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff o ..."
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NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.
The Asset Pricing Implications
, 2012
"... This paper studies the implications of parameter learning in general equilibrium, consumptionbased asset pricing models. Learning about the structural parameters that govern aggregate consumption dynamics introduces longrun risks in the subjective consumption dynamics, as posterior mean beliefs ar ..."
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This paper studies the implications of parameter learning in general equilibrium, consumptionbased asset pricing models. Learning about the structural parameters that govern aggregate consumption dynamics introduces longrun risks in the subjective consumption dynamics, as posterior mean beliefs are martingales and shocks to mean beliefs are permanent. These permanent shocks have particularly strong asset pricing implications for a representative agent with EpsteinZin preferences and a preference for early resolution of uncertainty. We show that even a simple economy where aggregate consumption growth is truly i.i.d., but where the representative agent learns in a Bayesian fashion about the mean growth rate, yields a high equity premium, excess volatility, a low riskfree rate, and excess return predictability. Casual intuition might suggest that the asset pricing implications of parameter learning in this case are highly transient, as rational agents learn quickly. We show that this intuition is incorrect when agents have a preference for early resolution of uncertainty: 100 year sample moments from a model with a reasonably calibrated prior belief yields an equity risk premium of 4.4 % —more than two and a half times the equity premium in the knownparameter, benchmark case. We also consider models with unknown parameters governing rare events, as well as learning in models with structural breaks. Unlike existing longrun risk models, the pricedividend ratios in these learning models do not predict future consumption growth. Further, the Hall (1978) riskfree rate regressions run on simulated model data yield estimates of the elasticity of intertemporal substitution close to zero, as in the data, despite the fact that the calibrated models have an elasticity of intertemporal substitution well above one. 1
Survival and longrun dynamics with heterogeneous beliefs under recursive preferences∗
, 2011
"... I study the longrun behavior of a twoagent economy where agents differ in their beliefs and are endowed with homothetic recursive preferences of the DuffieEpsteinZin type. When preferences are separable, the economy is dominated in the long run by the agent whose beliefs are relatively more prec ..."
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I study the longrun behavior of a twoagent economy where agents differ in their beliefs and are endowed with homothetic recursive preferences of the DuffieEpsteinZin type. When preferences are separable, the economy is dominated in the long run by the agent whose beliefs are relatively more precise, a result consistent with the market selection hypothesis. However, recursive preference specifications lead to equilibria in which both agents survive, or to ones where either agent can dominate the economy with a strictly positive probability. In this respect, the market selection hypothesis is not robust to deviations from separability. I derive analytical conditions for the existence of nondegenerate longrun equilibria, and show that these equilibria exist for plausible parameterizations when risk aversion is larger than the inverse of the intertemporal elasticity of substitution, providing a justification for models that combine belief heterogeneity and recursive preferences. ∗I am indebted to Lars Peter Hansen for his advice and continuous support. I appreciate helpful com