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Crises and recoveries in an empirical model of consumption disasters. Working Paper 15920
, 2010
"... We estimate an empirical model of consumption disasters using a new panel data set on consumption for 24 countries and more than 100 years. The model allows for permanent and transitory effects of disasters that unfold over multiple years. It also allows the timing of disasters to be correlated acro ..."
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Cited by 63 (3 self)
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We estimate an empirical model of consumption disasters using a new panel data set on consumption for 24 countries and more than 100 years. The model allows for permanent and transitory effects of disasters that unfold over multiple years. It also allows the timing of disasters to be correlated across countries. We estimate the model using Bayesian methods. Our estimates imply that the average length of disasters is roughly 5 years and that more than half of the short run impact of disasters on consumption are reversed in the long run on average. We investigate the asset pricing implications of these rare disasters. In a model with power utility and standard values for risk aversion, stocks surge at the onset of a disaster due to agents ’ strong desire to save. This causes a low equity premium, especially in normal times. In contrast, a model with EpsteinZinWeil preferences and an intertemporal elasticity of substitution equal to 2 yields a sizeable equity premium in normal times for modest values of risk aversion.
Disaster risk and business cycles
, 2009
"... This paper proposes a tractable business cycle model with large, volatile, and countercyclical risk premia. Risk premia are driven by a small, exogenously timevarying risk of economic disaster, and macroeconomic aggregates respond to this timevarying risk. The model is consistent with the second m ..."
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Cited by 25 (0 self)
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This paper proposes a tractable business cycle model with large, volatile, and countercyclical risk premia. Risk premia are driven by a small, exogenously timevarying risk of economic disaster, and macroeconomic aggregates respond to this timevarying risk. The model is consistent with the second moments of quantities, of asset returns, and matches well the relations between quantities and asset prices. An increase in the probability of disaster leads to a collapse of investment and a recession, with no current or future change in productivity. Demand for precautionary savings increases, leading yields on safe assets to fall, while spreads on risky securities increase. To assess the empirical validity of the model, I infer the probability of disaster from observed asset prices and feed it into the model. The variation over time in this probability appears to account for a signi…cant fraction of business cycle dynamics, especially sharp downturns in investment and output such as the last quarter of 2008. This is consistent with the thenwidespread fear of a repeat of the
Disasters implied by equity index options
, 2009
"... We use prices of equity index options to quantify the impact of extreme events on asset returns. We define extreme events as departures from normality of the log of the pricing kernel and summarize their impact with highorder cumulants: skewness, kurtosis, and so on. We show that highorder cumulan ..."
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Cited by 24 (5 self)
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We use prices of equity index options to quantify the impact of extreme events on asset returns. We define extreme events as departures from normality of the log of the pricing kernel and summarize their impact with highorder cumulants: skewness, kurtosis, and so on. We show that highorder cumulants are quantitatively important in both representativeagent models with disasters and in a statistical pricing model estimated from equity index options. Option prices thus provide independent confirmation of the impact of extreme events on asset returns, but they imply a more modest distribution of them.
Rare Disasters and Risk Sharing with Heterogeneous Beliefs
, 2012
"... Although the threat of rare economic disasters can have large effect on asset prices, difficulty in inference regarding both their likelihood and severity provides the potential for disagreements among investors. Such disagreements lead investors to insure each other against the types of disasters e ..."
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Cited by 15 (1 self)
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Although the threat of rare economic disasters can have large effect on asset prices, difficulty in inference regarding both their likelihood and severity provides the potential for disagreements among investors. Such disagreements lead investors to insure each other against the types of disasters each one fears the most. Due to the highly nonlinear relationship between consumption losses in a disaster and the risk premium, a small amount of risk sharing can significantly attenuate the effect that disaster risk has on the equity premium. The model has several predictions. First, it shows that time variation in the wealth distribution and the amount of disagreement across agents can significantly amplify the variation in disaster risk premium. Second, it provides caution to the approach of extracting disaster probabilities from asset prices, which can disproportionately reflect the beliefs of a small group of optimists and can either exaggerate or understate the variations in disaster probabilities over time. Third, the model predicts an inverse Ushaped relationship between the equity premium and the size of the disaster insurance market.
2011, Tails, fears and risk premia
 Journal of Finance
"... We show that the compensation for rare events accounts for a large fraction of the equity and variance risk premia in the S&P 500 market index. The probability of rare events vary significantly over time, increasing in periods of high market volatility, but the risk premium for tail events canno ..."
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Cited by 11 (0 self)
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We show that the compensation for rare events accounts for a large fraction of the equity and variance risk premia in the S&P 500 market index. The probability of rare events vary significantly over time, increasing in periods of high market volatility, but the risk premium for tail events cannot solely be explained by the level of the volatility. Our empirical investigations are essentially modelfree. We estimate the expected values of the tails under the statistical probability measure from “medium ” size jumps in highfrequency intraday prices and an extreme value theory approximation for the corresponding jump tail density. Our estimates for the riskneutral expectations are based on short maturity outofthe money options and new modelfree option implied variation measures explicitly designed to separate the tail probabilities. At a general level, our results suggest that any satisfactory equilibrium based asset pricing model must be able to generate large and timevarying compensations for fears of disasters.
Rare Disasters and Exchange Rates
, 2008
"... We propose a new model of exchange rates, which yields a theory of the forward premium puzzle. Our explanation combines two ingredients: the possibility of rare economic disasters, and an asset view of the exchange rate. Our model is frictionless, has complete markets, and works for an arbitrary num ..."
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Cited by 10 (0 self)
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We propose a new model of exchange rates, which yields a theory of the forward premium puzzle. Our explanation combines two ingredients: the possibility of rare economic disasters, and an asset view of the exchange rate. Our model is frictionless, has complete markets, and works for an arbitrary number of countries. In the model, rare worldwide disasters can occur and affect each country’s productivity. Each country’s exposure to disaster risk varies over time according to a meanreverting process. Risky countries command high risk premia: they feature a depreciated exchange rate and a high interest rate. As their risk premium mean reverts, their exchange rate appreciates. Therefore, currencies of high interest rate countries appreciate on average. To make the notion of disaster risk more implementable, we show how options prices might in principle uncover latent disaster risk, and help forecast exchange rate movements. We then extend the framework to incorporate two factors: a disaster risk factor, and a business cycle factor. We calibrate the model and obtain quantitatively realistic values for the volatility of the exchange rate, the forward premium puzzle regression coefficients, and nearrandom walk exchange rate dynamics. Finally, we solve a model of stock markets across countries, which yields a series of predictions about the joint behavior of exchange rates, bonds, options and stocks across countries. The evidence from the options market appears to be supportive of the
Issuer Quality and Corporate Bond Returns
, 2013
"... We show that the credit quality of corporate debt issuers deteriorates during credit booms, and that this deterioration forecasts low excess returns to corporate bondholders. The key insight is that changes in the pricing of credit risk disproportionately affect the financing costs faced by low qual ..."
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Cited by 9 (2 self)
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We show that the credit quality of corporate debt issuers deteriorates during credit booms, and that this deterioration forecasts low excess returns to corporate bondholders. The key insight is that changes in the pricing of credit risk disproportionately affect the financing costs faced by low quality firms, so the debt issuance of low quality firms is particularly useful for forecasting bond returns. We show that a significant decline in issuer quality is a more reliable signal of credit market overheating than rapid aggregate credit growth. We use these findings to investigate the forces driving timevariation in expected corporate bond returns.
Sources of entropy in representative agent models
, 2011
"... We propose two performance measures for asset pricing models and apply them to representative agent models with recursive preferences, habits, and jumps. The measures describe the pricing kernel’s dispersion (the entropy of the title) and dynamics (horizon dependence, a measure of how entropy varies ..."
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Cited by 9 (3 self)
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We propose two performance measures for asset pricing models and apply them to representative agent models with recursive preferences, habits, and jumps. The measures describe the pricing kernel’s dispersion (the entropy of the title) and dynamics (horizon dependence, a measure of how entropy varies over different time horizons). We show how each model generates entropy and horizon dependence, and compare their magnitudes to estimates derived from asset returns. This exercise — and transparent loglinear approximations — clarify the mechanisms underlying these models. It also reveals, in some cases, tension between entropy, which should be large enough to account for observed excess returns, and horizon dependence, which should be small enough to account for mean yield spreads.
A model of timevarying risk premia with habits and production
, 2012
"... This paper develops a new utility specification that incorporates Campbell—Cochrane—type habits into the Epstein—Zin class of preferences. In a simple calibration of a real business cycle model with EZhabit preferences, the model generates a strongly countercyclical equity premium, substantial equi ..."
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Cited by 8 (1 self)
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This paper develops a new utility specification that incorporates Campbell—Cochrane—type habits into the Epstein—Zin class of preferences. In a simple calibration of a real business cycle model with EZhabit preferences, the model generates a strongly countercyclical equity premium, substantial equity return predictability, and a stable riskless interest rate, as in the data. Moreover, conditional on the average level of risk aversion, timevariation in risk aversion increases the volatility and mean return of equities. On the real side, the model matches the short and longterm variances of output, consumption, and investment growth. As an additional empirical test, I measure implied risk aversion and find that it has an R2 of over 50 percent for 5year stock returns in postwar data. Variables that predict stock returns in the data also predict returns in the model with a similar degree of explanatory power.
Timeseries predictability in the disaster model
 Finance Research Letters
, 2008
"... This paper studies whether the RietzBarro “disaster”model, extended for a timevarying probability of disaster, can match the empirical evidence on predictability of stock returns. It is shown that when utility is CRRA, the model cannot replicate these …ndings, regardless of parameter values. This ..."
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Cited by 8 (1 self)
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This paper studies whether the RietzBarro “disaster”model, extended for a timevarying probability of disaster, can match the empirical evidence on predictability of stock returns. It is shown that when utility is CRRA, the model cannot replicate these …ndings, regardless of parameter values. This motivates extending the disaster model to allow for EpsteinZin utility. Analytical results show that when the probability of disaster is iid, the model with EpsteinZin utility can match the evidence on predictability qualitatively if the elasticity of substitution is greater than unity. The case of a persistent probability of disaster is studied numerically, with partial success. 1