Hidden persistent disasters and asset prices
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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.
KeywordsAsset pricing Equity premium Equity volatility Persistent disasters Stochastic differential utility
JEL ClassificationC61 E21 G12
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.
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