Advertisement

Annals of Finance

, Volume 10, Issue 3, pp 395–418 | Cite as

Hidden persistent disasters and asset prices

  • Masataka SuzukiEmail author
Research Article
  • 281 Downloads

Abstract

This study analyzes the effects of agents’ learning about hidden persistent economic disasters on asset prices. In this study, it is assumed that aggregate consumption follows a hidden Markov regime-switching process and a representative agent infers the current regime, normal regime, or disaster regime, sequentially from the realized path of the past consumption process. In this setting, the fluctuation in the agent’s posterior probabilities of the disaster regime augments the volatility of equity returns. By utilizing the stochastic differential utility, this study demonstrates that the current model can help resolve many asset pricing puzzles including the equity premium puzzle, equity volatility puzzle, and risk-free rate puzzle simultaneously. Further, the current model predicts the counter-cyclical pattern in the equity premium and equity-return volatility on the normal regime, although asset returns are negative and highly volatile during disasters. The study also demonstrates that, if the agent’s preferences are restricted to time-additive power utility, the consideration of hidden persistent disasters deepens the asset pricing puzzles.

Keywords

Asset pricing Equity premium Equity volatility  Persistent disasters Stochastic differential utility 

JEL Classification

C61 E21 G12 

Notes

Acknowledgments

I am very grateful for helpful comments from Makoto Saito, Hajime Takahashi, Eiji Kurozumi, Etsuro Shioji, and Makoto Nirei. I also thank anonymous referees and the editor Rajnish Mehra for their insightful suggestions for improving this study. All errors are my own.

References

  1. Abel, A.B.: Risk premia and term premia in general equilibrium. J Monet Econ 43, 3–33 (1999)CrossRefGoogle Scholar
  2. Bansal, R., Yaron, A.: Risks for the long-run: a potential resolution of asset pricing puzzles. J Financ 59, 1481–1509 (2004)CrossRefGoogle Scholar
  3. Barro, R.J.: Rare disasters and asset markets in the twentieth century. Q J Econ 121, 823–866 (2006)CrossRefGoogle Scholar
  4. Barro, R.J., Ursúa, J.F.: Macroeconomic crises since 1870. Brook Pap Econ Act, pp. 255–350 (2008)Google Scholar
  5. Beeler, J., Campbell, J.Y.: The long-run risks model and aggregate asset prices: an empirical assessment. Crit Financ Rev 1, 141–182 (2012)CrossRefGoogle Scholar
  6. Boudoukh, J., Michaely, R., Richardson, M., Roberts, M.R.: On the importance of measuring payout yields: implications for empirical asset pricing. J Financ 62, 877–915 (2007)CrossRefGoogle Scholar
  7. Campbell, J.Y.: Asset prices, consumption and the business cycle. In: Taylor, J., Woodford, M. (eds.) Handbook of Macroeconomics, vol. 1, pp. 1231–1303. Amsterdam: North Holland (1999)Google Scholar
  8. Campbell, J.Y., Cochrane, J.H.: By force of habit: a consumption-based explanation of aggregate stock market behavior. J Polit Econ 107, 205–251 (1999)CrossRefGoogle Scholar
  9. Constantinides, G.M., Ghosh, A.: Asset pricing tests with long-run risks in consumption growth. Rev Asset Pricing Stud 1, 96–136 (2011)CrossRefGoogle Scholar
  10. Duffie, D., Epstein, L.G.: Stochastic differential utility. Econometrica 60, 353–394 (1992)CrossRefGoogle Scholar
  11. Duffie, D., Skiadas, C.: Continuous-time asset pricing: a utility gradient approach. J Math Econ 23, 107–132 (1994)CrossRefGoogle Scholar
  12. Epstein, L.G., Zin, S.E.: Substitution, risk aversion, and the temporal behavior of consumption and asset return: a theoretical framework. Econometrica 57, 937–969 (1989)CrossRefGoogle Scholar
  13. Gabaix, X.: Variable rare disasters: a tractable theory of ten puzzles in macro-finance. Am Econ Rev 98, 64–67 (2008)CrossRefGoogle Scholar
  14. Gabaix, X.: Variable rare disasters: an exactly solved framework for ten puzzles in macro-finance. Q J Econ 127, 645–700 (2012)CrossRefGoogle Scholar
  15. Gruber, J.: A tax-based estimate of the elasticity of intertemporal substitution. NBER Working Paper 11945 (2006)Google Scholar
  16. Hall, R.E.: Intertemporal substitution in consumption. J Polit Econ 96, 339–357 (1988)CrossRefGoogle Scholar
  17. Israel, R.B., Rosenthal, J.S., Wei, J.Z.: Finding generators for Markov chains via empirical transition matrices with applications to credit ratings. Math Financ 11, 245–265 (2001)CrossRefGoogle Scholar
  18. Julliard, C., Ghosh, A.: Can rare events explain the equity premium puzzle? Rev Financ Stud 25, 3037–3076 (2012)Google Scholar
  19. Liptser, R.N., Shiryaev, A.N.: Statistics of Random Processes I, 2nd edn. Springer, Berlin/Heidelberg (2001)CrossRefGoogle Scholar
  20. Marakani, S.: Long run consumption risks: are they there? Working Paper (2009)Google Scholar
  21. Mehra, R., Prescott, E.: The equity risk premium: a puzzle. J Monet Econ 15, 145–161 (1985)CrossRefGoogle Scholar
  22. Nakamura, E., Steinsson, J., Barro, R.J., Ursúa, J.F.: Crises and recoveries in an empirical model of consumption disasters. Working Paper (2011)Google Scholar
  23. Rietz, T.A.: The equity risk premium: a solution. J Monet Econ 22, 117–131 (1988)CrossRefGoogle Scholar
  24. Saito, M., Suzuki, S.: Persistent catastrophic shocks and equity premium: a note. Macroecon Dyn (2013) (forthcoming). doi: 10.1017/S1365100512000740
  25. Shiller, R.: Do stock prices move too much to be justified by subsequent changes in dividends? Am Econ Rev 71, 421–436 (1981)Google Scholar
  26. Veronesi, P.: The peso problem hypothesis and stock market returns. J Econ Dyn Control 28, 707–725 (2004)CrossRefGoogle Scholar
  27. Wachter, J. A.: Can time-varying risk of rare disasters explain aggregate stock market volatility? J Financ (2013) (forthcoming). doi: 10.1111/jofi.12018
  28. Weil, P.: The equity risk premium puzzle and the risk-free rate puzzle. J Monet Econ 24, 401–421 (1989)CrossRefGoogle Scholar
  29. Weil, P.: Nonexpected utility in macroeconomics. Q J Econ 105, 29–42 (1990)CrossRefGoogle Scholar

Copyright information

© Springer-Verlag Berlin Heidelberg 2013

Authors and Affiliations

  1. 1.Department of EconomicsMusashi UniversityTokyoJapan

Personalised recommendations