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92
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.
Option prices in a model with stochastic disaster risk ∗ Sang Byung Seo
, 2013
"... In a challenge to models that link the equity premium to rare disasters, Backus, Chernov, and Martin (2011) show that data on options imply negative events that are far smaller than these models suggest. We show that this result depends critically on the assumption that the probability of the rare e ..."
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Cited by 7 (2 self)
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In a challenge to models that link the equity premium to rare disasters, Backus, Chernov, and Martin (2011) show that data on options imply negative events that are far smaller than these models suggest. We show that this result depends critically on the assumption that the probability of the rare event is constant. That is, a model with stochastic jumps in consumption can simultaneously explain options data and the equity premium. Indeed, such a model delivers an excellent fit to implied volatilities, despite being calibrated to match the equity premium and equity volatility alone.
Rare booms and disasters in a multi sector endowment economy”. Working paper,
, 2013
"... Abstract Why do value stocks have higher expected returns than growth stocks, in spite of having lower risk? Why do these stocks exhibit positive abnormal performance while growth stocks exhibit negative abnormal performance? This paper offers a rareevents based explanation, that can also account f ..."
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Cited by 6 (2 self)
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Abstract Why do value stocks have higher expected returns than growth stocks, in spite of having lower risk? Why do these stocks exhibit positive abnormal performance while growth stocks exhibit negative abnormal performance? This paper offers a rareevents based explanation, that can also account for facts about the aggregate market. Patterns in timeseries predictability offer independent evidence for the model's conclusions.
Credit Risk and Disaster Risk”.
 American Economic Journal: Macroeconomics,
, 2013
"... Abstract Standard macroeconomic models imply that credit spreads directly re ‡ect expected losses (the probability of default and the loss in the event of default). In contrast, in the data credit spreads are signi…cantly larger than expected losses, suggestive of an aggregate risk premium. Buildin ..."
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Abstract Standard macroeconomic models imply that credit spreads directly re ‡ect expected losses (the probability of default and the loss in the event of default). In contrast, in the data credit spreads are signi…cantly larger than expected losses, suggestive of an aggregate risk premium. Building on the idea that corporate debt, while safe in normal times, is exposed to economic depressions, this paper embeds a tradeo¤ theory of capital structure into a real business cycle model with a small, timevarying risk of economic disaster. The model replicates the level, volatility and cyclicality of credit spreads, and variation in the corporate bond premium ampli…es macroeconomic ‡uctuations in investment, employment and GDP. JEL: E32, E44, G12.
Risk Premia and the Conditional Tails of Stock Returns. Unpublished Working Paper.
, 2009
"... Abstract Theory suggests that the risk of infrequent yet extreme events has a large impact on asset prices. Testing models of this hypothesis remains a challenge due to the difficulty of measuring tail risk fluctuations over time. I propose a new measure of timevarying tail risk that is motivated ..."
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Cited by 6 (0 self)
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Abstract Theory suggests that the risk of infrequent yet extreme events has a large impact on asset prices. Testing models of this hypothesis remains a challenge due to the difficulty of measuring tail risk fluctuations over time. I propose a new measure of timevarying tail risk that is motivated by asset pricing theory and is directly estimable from the cross section of returns. My procedure applies
Disaster begets crisis: The role of contagion in financial markets, working paper
, 2011
"... Severe economic downturns like the great depression of the 1930s take place over extended periods of time. I model an economy where rare economic disasters increase the likelihood of subsequent near term disasters. The mechanism generates more clustering of disasters than existing models. Serial cor ..."
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Cited by 5 (0 self)
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Severe economic downturns like the great depression of the 1930s take place over extended periods of time. I model an economy where rare economic disasters increase the likelihood of subsequent near term disasters. The mechanism generates more clustering of disasters than existing models. Serial correlation in disasters has important implications for asset prices. For example, it generates a larger equity premium and a lower risk free rate than similarly calibrated models without this feature. The calibrated model developed here replicates the temporal structure of severe economic downturns in OECD countries. It quantitatively explains the equity premium, the riskfree rate, excess volatility and return predictability. It also generates the implied volatility smile observed in equity index options. I want to thank my dissertation committee Mark Grinblatt (chair), Antonio Bernardo, Hanno Lustig,
Asset Pricing with Countercyclical Household Consumption Risk
, 2014
"... We present evidence that shocks to household consumption growth are negatively skewed, persistent, and countercyclical and play a major role in driving asset prices. We construct a parsimonious model with one state variable that drives the conditional crosssectional moments of household consumption ..."
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Cited by 5 (1 self)
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We present evidence that shocks to household consumption growth are negatively skewed, persistent, and countercyclical and play a major role in driving asset prices. We construct a parsimonious model with one state variable that drives the conditional crosssectional moments of household consumption growth. The estimated model provides a good fit for the moments of the crosssectional distribution of household consumption growth and the unconditional moments of the risk free rate, equity premium, market pricedividend ratio, and aggregate dividend and consumption growth. The explanatory power of the model does not derive from possible predictability of aggregate dividend and consumption growth as these are intentionally modeled as i.i.d. processes. Consistent with empirical evidence, the model implies that the risk free rate and pricedividend ratio are procyclical while the expected market return and the variance of the market return and risk free rate are countercyclical. Household consumption risk also explains the crosssection of excess returns.
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,
Asset Allocation
 Annual Reviews of Financial Economics
, 2010
"... This review article describes recent literature on asset allocation, covering both static and dynamic models. The article focuses on the bond–stock decision and on the implications of return predictability. In the static setting, investors are assumed to be Bayesian, and the role of various prior be ..."
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This review article describes recent literature on asset allocation, covering both static and dynamic models. The article focuses on the bond–stock decision and on the implications of return predictability. In the static setting, investors are assumed to be Bayesian, and the role of various prior beliefs and specifications of the likelihood are explored. In the dynamic setting, recursive utility is assumed, and attention is paid to obtaining analytical results when possible. Results under both full and limitedinformation assumptions are discussed.
Crash risk in currency markets
, 2009
"... Abstract Since the Fall of 2008, outofthe money puts on high interest rate currencies have become significantly more expensive than outofthemoney calls, suggesting a large crash risk of those currencies. To evaluate crash risk precisely, we propose a parsimonious structural model that includes ..."
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Abstract Since the Fall of 2008, outofthe money puts on high interest rate currencies have become significantly more expensive than outofthemoney calls, suggesting a large crash risk of those currencies. To evaluate crash risk precisely, we propose a parsimonious structural model that includes both Gaussian and disaster risks and can be estimated even in samples that do not contain disasters. Estimating the model for the 1996 to 2014 sample period using monthly exchange rate spot, forward, and option data, we obtain a realtime index of the compensation for global disaster risk exposure. We find that disaster risk accounts for more than a third of the carry trade risk premium in advanced countries over the period examined. The measure of disaster risk that we uncover in currencies proves to be an important factor in the crosssectional and timeseries variation of exchange rates, interest rates, and equity tail risk.