Mehra and Prescott assert σ = 10 as extreme upper bound on risk aversion

Similar documents
ASSET PRICING IN INTERTEMPORAL CONSUMPTION MODELS OCTOBER 5, 2011 ASSET PRICING APPLICATIONS. The Border of Macro and Finance

You should turn in (at least) FOUR bluebooks, one (or more, if needed) bluebook(s) for each question.

Stylized fact: high cyclical correlation of monetary aggregates and output

SIMPLE DSGE MODELS OF MONEY DEMAND: PART I OCTOBER 14, 2014

MA Advanced Macro, 2016 (Karl Whelan) 1

Money/monetary policy issues an enduring fascination in macroeconomics. How can/should central bank control the economy? Should it/can it at all?

UCLA Department of Economics Fall PhD. Qualifying Exam in Macroeconomic Theory

Econ 546 Lecture 4. The Basic New Keynesian Model Michael Devereux January 2011

EQUILIBRIUM ASSET PRICING MODELS

Follow links for Class Use and other Permissions. For more information send to:

CENTRO DE ESTUDIOS MONETARIOS Y FINANCIEROS T. J. KEHOE MACROECONOMICS I WINTER 2011 PROBLEM SET #6

Problem 1 / 25 Problem 2 / 25 Problem 3 / 11 Problem 4 / 15 Problem 5 / 24 TOTAL / 100

PROSPECT THEORY AND ASSET PRICES

THE TWO-PERIOD MODEL (CONTINUED)

CALIBRATING THE (RBC + SOLOW) MODEL JANUARY 31, 2013

Consumption Based Asset Pricing Models: Theory

Policyholder Exercise Behavior for Variable Annuities including Guaranteed Minimum Withdrawal Benefits 1

Money in a Real Business Cycle Model

This specification describes the models that are used to forecast

Chapter 8 Consumption and Portfolio Choice under Uncertainty

R e. Y R, X R, u e, and. Use the attached excel spreadsheets to

CHAPTER CHAPTER18. Openness in Goods. and Financial Markets. Openness in Goods, and Financial Markets. Openness in Goods,

The Mathematics Of Stock Option Valuation - Part Four Deriving The Black-Scholes Model Via Partial Differential Equations

Macroeconomics II A dynamic approach to short run economic fluctuations. The DAD/DAS model.

MAFS Quantitative Modeling of Derivative Securities

a) No constraints on import- export, no limit on reservoir, all water in the first period The monopoly optimisation problem is:

Real Business Cycles. Chapter III. 1 What is the Business Cycle? Professor Thomas Chaney

Final Exam Answers Exchange Rate Economics

Data Mining Anomaly Detection. Lecture Notes for Chapter 10. Introduction to Data Mining

Data Mining Anomaly Detection. Lecture Notes for Chapter 10. Introduction to Data Mining

Evaluating Projects under Uncertainty

Appendix B: DETAILS ABOUT THE SIMULATION MODEL. contained in lookup tables that are all calculated on an auxiliary spreadsheet.

Section 4 The Exchange Rate in the Long Run

Elton, Gruber, Brown, and Goetzmann. Modern Portfolio Theory and Investment Analysis, 7th Edition. Solutions to Text Problems: Chapter 21

Models of Default Risk

ANSWER ALL QUESTIONS. CHAPTERS 6-9; (Blanchard)

Business Cycle Theory I (REAL)

2. Quantity and price measures in macroeconomic statistics 2.1. Long-run deflation? As typical price indexes, Figure 2-1 depicts the GDP deflator,

Economics 2450A: Public Economics Section 9: Linear Capital Taxation

Incorporating Risk Preferences into Real Options Models. Murat Isik

An Innovative Thinking on the Concepts of Ex-Ante Value, Ex-Post Value and the Realized Value (Price)

Monetary policy and multiple equilibria in a cash-in-advance economy

Jarrow-Lando-Turnbull model

Cash-flow Risk, Discount Risk, and the Value Premium

Nominal Rigidities, Asset Returns and Monetary Policy

4452 Mathematical Modeling Lecture 17: Modeling of Data: Linear Regression

Parameter Uncertainty: The Missing Piece of the Liquidity Premium Puzzle?

An Incentive-Based, Multi-Period Decision Model for Hierarchical Systems

A Note on Missing Data Effects on the Hausman (1978) Simultaneity Test:

NOMINAL RIGIDITIES IN A DSGE MODEL: THE PERSISTENCE PUZZLE OCTOBER 14, 2010 EMPIRICAL EFFECTS OF MONETARY SHOCKS. Empirical Motivation

Taking into account extreme events in European option pricing

The macroeconomic effects of fiscal policy in Greece

Systemic Risk Illustrated

INSTITUTE OF ACTUARIES OF INDIA

Reconciling Gross Output TFP Growth with Value Added TFP Growth

Li Gan Guan Gong Michael Hurd. April, 2006

The Bond Premium in a DSGE Model with Long-Run Real and Nominal Risks

Contributions to Macroeconomics

Macroeconomics II THE AD-AS MODEL. A Road Map

Productivity-Based Asset Pricing: Theory and Evidence

(a) Assume that the entrepreneur is willing to undertake the project, and analyze the problem from the point of view of the outside investor.

Chapter Outline CHAPTER

The Simple Analytics of Price Determination

Wealth Effects (Plural) and U.S. Consumer Spending *

Transactions, Credit, and Central Banking in a Model of Segmented Markets

CAN THE CONSUMPTION-FREE NONEXPECTED UTILITY MODEL SOLVE THE RISK PREMIUM PUZZLE? AN EMPIRICAL STUDY OF THE JAPANESE STOCK MARKET

Rare Disasters and Risk Sharing with Heterogeneous Beliefs

FORECASTING WITH A LINEX LOSS: A MONTE CARLO STUDY

NBER WORKING PAPER SERIES RARE DISASTERS, ASSET PRICES, AND WELFARE COSTS. Robert J. Barro. Working Paper

Midterm Exam. Use the end of month price data for the S&P 500 index in the table below to answer the following questions.

Macroeconomics Sequence, Block I. Introduction to Consumption Asset Pricing

A New Solution to the Equity Premium Puzzle and the Risk-Free Rate Puzzle: Theory and Evidence

Problem Set 1 Answers. a. The computer is a final good produced and sold in Hence, 2006 GDP increases by $2,000.

Forecasting with Judgment

MARKET ORGANIZATION AND THE PRICES OF FINANCIAL ASSETS*

COOPERATION WITH TIME-INCONSISTENCY. Extended Abstract for LMSC09

INSTITUTE OF ACTUARIES OF INDIA

Negative Swap Spreads and Limited Arbitrage

Macroeconomics. Part 3 Macroeconomics of Financial Markets. Lecture 8 Investment: basic concepts

SMALL MENU COSTS AND LARGE BUSINESS CYCLES: AN EXTENSION OF THE MANKIW MODEL

Option Valuation of Oil & Gas E&P Projects by Futures Term Structure Approach. Hidetaka (Hugh) Nakaoka

The Great Recession gave way to a period of very low short-term

Chapter 10: The Determinants of Dividend Policy

Financial Markets And Empirical Regularities An Introduction to Financial Econometrics

FINAL EXAM EC26102: MONEY, BANKING AND FINANCIAL MARKETS MAY 11, 2004

Less of a puzzle: a new look at the forward forex market

a. If Y is 1,000, M is 100, and the growth rate of nominal money is 1 percent, what must i and P be?

Habits and Leverage. Tano Santos * Columbia University. Pietro Veronesi ** University of Chicago

Economic Growth Continued: From Solow to Ramsey

Pricing FX Target Redemption Forward under. Regime Switching Model

House Price Bubbles and Debt Default in a DSGE model *

Stochastic volatility implies fourth-degree risk dominance: Applications to asset pricing

Economics 602 Macroeconomic Theory and Policy Problem Set 9 Professor Sanjay Chugh Spring 2012

Essays in Asset Pricing

Optimal Early Exercise of Vulnerable American Options

In a calibrated representative agent model, Lucas (1987) shows a very insignificant welfare

Market and Information Economics

Exam 1. Econ520. Spring 2017

The Cox-Ingersoll-Ross Model

OPTIMUM FISCAL AND MONETARY POLICY USING THE MONETARY OVERLAPPING GENERATION MODELS

Transcription:

ADDRESSING THE EQUITY PREMIUM AND RISK-FREE RATE PUZZLES OCTOBER, 2 Seminal Finance Applicaion EQUITY PREMIUM PUZZLE s (( + /,/ + σ Cov c c R E s = R R σ + Ec ( + / c Wha are reasonable values o RRA? Business-cycle models require σ (Econ 7 Microeconomic evidence higher(? risk aversion Hall (988 evidence indicaes IES σ. I CRRA σ (Though Hall disavows ha he is measuring risk aversion Kocherlakoa says argumen is deeply lawed (99, JFin p. 75 Mehra and Presco asser σ = as exreme upper bound on risk aversion σ = Sandard model explains.3 percen o he 6 percen equiy premium An order o magniude o! Even hough σ = already oo high (? Explaining equiy premium wih sandard model requires σ 5! Ocober, 2 2

Seminal Finance Applicaion EQUITY PREMIUM AND RISK-FREE RATE PUZZLES σ c + ( β E = (2 c / R s (( + /,/ + σ Cov c c R E s = R R σ + Ec ( + / c σ = Sandard model explains.3 percen o he 6 percen equiy premium An order o magniude o! Explaining equiy premium wih sandard model requires σ 5! I accep σ 5 Requires acceping virually zero IES (no inconsisen wih Hall 988 and generaes anoher anomaly I prior is β.98-.99, ( implies /R. percen higher han empirical risk-ree rae! (Exremely high σ o ix equiy premium puzzle causes risk-ree rae puzzle! Which can be ose by β.6 exreme impaience! Hyperbolic? Ocober, 2 3 Seminal Finance Applicaion EQUITY PREMIUM AND RISK-FREE RATE PUZZLES σ c + ( β E = (2 c / R s (( + /,/ + σ Cov c c R E s = R R σ + Ec ( + / c Wih CRRA preerences, resolving boh puzzles requires adoping view ha consumers are EXTREMELY risk averse CRRA undamenally enangles risk aiudes EXTREMELY impaien and ineremporal aiudes Many assumpions underlying basic model No ransacions coss in inancial markes Everyone paricipaes in all inancial markes i.e., no limied paricipaion A represenaive agen exiss i.e., can ignore heerogeneiy in aggregaing Euler equaions (recalls Aanasio criicism o Hall (978 Ec Firs (mos naural? line o aack modiy u(. o disenangle IES and RRA Ocober, 2 4 2

The Border o Macro and Finance ASSET PRICING APPLICATIONS Lucas-ree model General equilibrium asse pricing Equiy premium puzzle Risk-ree rae puzzle Alernaive preerence speciicaions Recursive uiliy (Epsein-Zin Habi persisence Hyperbolic discouning Risk sharing (Consrucing he represenaive consumer Ocober, 2 5 Equiy Premium Puzzle EXPECTED UTILITY CRRA uiliy σ c u( c = σ IES = and RRA( c = σ σ Ocober, 2 6 3

Equiy Premium Puzzle EXPECTED UTILITY a Beginning o planning horizon CRRA uiliy σ c u( c = σ IES = and RRA( c = σ σ For any u(c, sandard liecycle model is in class o expeced uiliy models Economic oucomes during period : income, consumpion, savings Period a Probabiliy q: Realizaion y2 H Probabiliy p: Realizaion y2bar Probabiliy -p-q: Realizaion y2 L a2 Uiliy o risky evens = E(uiliy o he possible risky oucomes von-neumann-morgensern axiomiizaion: INDEPENDENCE AXIOM he mos criical Inuiively: uiliy is addiively separable over he risky oucomes and linear in he probabiliies (Much more deail in Econ 63/64! End o planning horizon Economic oucomes during period 2: sochasic income, sae-coningen consumpion, savings Ocober, 2 7 Equiy Premium Puzzle EXPECTED UTILITY Expeced uiliy Exogenous sae vecor z ollows known Markov process s ma x E β u( c s { cs, as} s= s= { u + β V( a } V( a ; z = max ( c E ; z c, a + Deerminisic case s max β uc ( s { cs, a s } s= s= Addiively separable in he risky oucomes and linear in he probabiliies { uc βv a } V( a max ( ( = c, a + Ocober, 2 8 4

Equiy Premium Puzzle Epsein-Zin / Kreps-Poreus uiliy Exogenous sae vecor z ollows known Markov process V( a ; z = max u( c + β c, a ( ; V a z + Curvaure over he risky oucomes and nonlinear in he probabiliies α, α Typical represenaion in lieraure ρ ρ ρ α α ; = m x β ( + c, a V ( a z a c + E V( a ; z Obain more general represenaion by seing V = V ρ α = α ρ Ocober, 2 9 Equiy Premium Puzzle Epsein-Zin / Kreps-Poreus uiliy Exogenous sae vecor z ollows known Markov process V( a ; z = max u( c + β c, a ( ; V a z + Curvaure over he risky oucomes and nonlinear in he probabiliies α, α α = back o expeced uiliy! α require some more condiions on u(. and α I u(., hen V(. (E-Z 989 Theorem 3. α > corresponds o risk aversion [over wha?...] Larger values o α represen greaer degree o risk aversion Ocober, 2 5

Equiy Premium Puzzle Epsein-Zin / Kreps-Poreus uiliy Exogenous sae vecor z ollows known Markov process V( a ; z = max u( c + β c, a ( ; V a z + α, α α = back o expeced uiliy! Curvaure over he risky oucomes and nonlinear in he probabiliies (reormulae he recursion i u(. α require some more condiions on u(. and α I u(., hen V(. (E-Z 989 Theorem 3. α > corresponds o risk aversion [over wha?...] Larger values o α represen greaer degree o risk aversion I u(., hen reormulae he recursion as ( β E V( a; z +, and V(. (E-Z 989 Theorem 3. α > corresponds o risk aversion [over wha?...] Larger values o α represen lesser degree o risk aversion Ocober, 2 Equiy Premium Puzzle Epsein-Zin / Kreps-Poreus uiliy Exogenous sae vecor z ollows known Markov process V( a ; z = max u( c + β c, a ( ; V a z + Curvaure over he risky oucomes and nonlinear in he probabiliies α, α α = back o expeced uiliy! α require some more condiions on u(. and α I u(., hen V(. (E-Z 989 Theorem 3. α > corresponds o risk aversion [over wha?...] Larger values o α represen greaer degree o risk aversion Deerminisic case V( a { u βv ( z } ; z = max ( c + a ; c, a + Pursue his case wihou loss o generaliy Idenical o sandard model i no uncerainy! Ocober, 2 2 6

Equiy Premium Puzzle Epsein-Zin / Kreps-Poreus uiliy V( a ; z = max u( c + β c, a ( ; V a z + Sequenial represenaion? NONE! Primiive IS he value uncion Reason: sae-non-separable preerences Bu ime-separable preerences α, α Can inerpre preerences as being deined over Curren-period consumpion, c Asses a he end o curren period/beginning o nex period, a a links curren period o sae j, j, nex period hrough budge consrain(s Common inerpreaion o α Curren period j j j j c + a = y + ( + r a c + + a + = y + + ( + r + a Twiss and unwiss he value uncion Sae j nex period Ocober, 2 3 Equiy Premium Puzzle Consumer problem FOCs V( a ; max ( z = u c + λ c, a y + ( + r a a + E V( a; z+ [ ] ( c β α c : u'( c λ = a : Env : V( a ; z = λ( + r Ocober, 2 4 7

Equiy Premium Puzzle Consumer problem FOCs V( a ; max ( z = u c + λ c, a y + ( + r a a + E V( a; z+ [ ] ( c β α c : u'( c λ = a : Env : V( a ; z = λ( + r Euler equaion Isolae pricing kernel Ocober, 2 5 Equiy Premium Puzzle Asse pricing represenaion βu ( c V( a ; z = + r + V( a; z+ + + E ( u'( c Pricing kernel aka sochasic discoun acor (SDF α = collapses SDF o sandard IMRS Wih sae-non-separable (i.e., α, kernel depends on IMRS (sandard Value uncion isel!...which in urns depends on wealh How o measure V(.?...i s uils How o measure α? Ocober, 2 6 8

Equiy Premium Puzzle Asse pricing represenaion βu ( c V( a; z d s + + + + + = E u'( c s R V( a; z+ βu ( c V( a ; z + + = E u'( c V( a; z+ R Equiy premium Bonds So does recursive uiliy model help? No clear Disenangling RRA rom IES is useul bu sill require (very high RRA! Lack o empirical guidance on α a shorcoming (Noe: α parameer does no EQUAL RRA requires more general analysis Also problemaic: pricing kernel no invarian o level shis o u(. Ocober, 2 7 Equiy Premium Puzzle How o compue IES? From deerminisic model since IES is a concep disinc rom risk V( a I assume CRRA u(c, IES is { u βv ( z } ; z = max ( c + a ; c, a + IES = σ No dieren rom expeced uiliy model So can have IES (or lower, ollowing Hall (988 and RRA >> simulaneously How o empirically pin down risk aversion parameer in recursive preerences? Work jus beginning now Ocober, 2 8 9

The Border o Macro and Finance ASSET PRICING APPLICATIONS Lucas-ree model General equilibrium asse pricing Equiy premium puzzle Risk-ree rae puzzle Alernaive preerence speciicaions Recursive uiliy (Epsein-Zin Habi persisence Hyperbolic discouning Risk sharing (Consrucing he represenaive consumer Ocober, 2 9 Equiy Premium Puzzle Wha i wan o reain expeced uiliy heory? Local risk aversion can be inroduced by supposing lagged consumpion aecs uiliy vc (, c Time-non-separable preerences Sae-separable preerences More generally, could be v(c, c -, c -2,, c -τ As long as resric o inie lags (o preserve Markov propery Illusrae wih one lag: v(c, c - Ocober, 2 2

Equiy Premium Puzzle Wha i wan o reain expeced uiliy heory? Local risk aversion can be inroduced by supposing lagged consumpion aecs uiliy vc (, c Time-non-separable preerences Sae-separable preerences More generally, could be v(c, c -, c -2,, c -τ As long as resric o inie lags (o preserve Markov propery Illusrae wih one lag: v(c, c - Two ypical ormulaions Muliplicaive habis Addiive (subracive habis c vc (, c =, γ [,] c γ v( c, c = u( c c, α [,] Pursue his ormulaion Sequenial and recursive ormulaions max E β u( c αc { c, a} = = sae vecor? { u c V a z } V( a, c ; z = max ( +β E (, c ; c, a Ocober, 2 2 Equiy Premium Puzzle max E β u( c αc { c, a} = subjec o c + a = y + ( + r a, =,, 2,... = FOCs c : a : c delivers DISUTILITY in period + because o pre-accumulaed habis/addicions u '( c αβ '( α λ = αc Eu c+ c [ r ] λ + βe λ + (+ + = Euler equaion α αβ '( c αc β ( α αβ E u'( c α u'( c c Eu + = E u' ( c+ c + + 2 c+ ( + r+ Ocober, 2 22

Equiy Premium Puzzle max E β u( c αc { c, a} = subjec o c + a = y + ( + r a, =,, 2,... = FOCs c : a : c delivers DISUTILITY in period + because o pre-accumulaed habis/addicions u '( c αβ '( α λ = αc Eu c+ c [ r ] λ + βe λ + (+ + = Euler equaion α αβ '( c αc β ( α αβ E u'( c α u'( c c Eu + = E u' ( c+ c + + 2 c+ ( + r+ β( u' ( c+ c β E+ u'( c+ 2 c+ u'( c αc β Eu'( c c = E ( + r + + Pricing kernel aka sochasic discoun acor (SDF Los o leads and lags makes kernel more lexible, in hope(? ha can beer mach asse-pricing acs Ocober, 2 23 Equiy Premium Puzzle { α λ [ y c + r ] + β V a } V( a, c ; z = max u( c c + + a ( a E (, c ; z c, a + FOCs c : a : Env wr a : Env wr c : Euler equaion Ocober, 2 24 2

Equiy Premium Puzzle Asse pricing equaions β( '( β E+ u'( c+ 2 c+ '( βeu' ( c c u c c d + s + + + = E u c c + s R = E β ( u c+ c β E+ u'( c+ 2 c+ β Eu '( u'( c c '( c+ c R Equiy premium Bonds Ocober, 2 25 Equiy Premium Puzzle Asse pricing equaions β( '( β E+ u'( c+ 2 c+ '( α αβeu' ( c αc u c c d + s E + + + = u c c + s R = E β ( u c+ c β E+ u'( c+ 2 c+ β Eu '( u'( c c '( c+ c R Equiy premium Bonds Why migh habis help solve equiy premium and risk-ree rae puzzle? Back-o-envelope: compue RRA wih respec o c, given CRRA speciicaion c - c α.8 (empirical esimaes using macro daa 2 2 c u/ c σ c RRA( c = = 5σ u/ c c c Pumps up RRA by acor o 5 Ocober, 2 26 3

Equiy Premium Puzzle Asse pricing equaions β( '( β E+ u'( c+ 2 c+ '( βeu' ( c c u c c d + s + + + = E u c c + s R = E β ( u c+ c β E+ u'( c+ 2 c+ β Eu '( u'( c c '( c+ c R Equiy premium Bonds Why migh habis help solve equiy premium and risk-ree rae puzzle? Back-o-envelope: compue RRA wih respec o c, given CRRA speciicaion c - c α.8 (empirical esimaes using macro daa 2 2 c u/ c σ c RRA( c = = 5σ u/ c c c Pumps up RRA by acor o 5 So does habi model help? Yes on risk-ree rae puzzle, less so on equiy premium puzzle, which sill requires implausibly high risk aversion Ocober, 2 27 Equiy Premium Puzzle EQUITY PREMIUM PUZZLE? Oher explanaions o equiy premium and risk-ree rae puzzles? Borrowing consrains Transacions coss o inancial marke rading Limied paricipaion in inancial markes Small probabiliies o disasers / black swans Long-run risk (i.e., changes o he growh rend Heerogeneous individuals Myopic behavior (sor o like hyperbolic A saisical ariac?...! An avalanche o lieraure in macro and inance since Mehra and Presco (985 Overviews Kocherlakoa (996 Journal o Economic Lieraure Mehra and Presco (23, Handbook o Economics o Finance, Chaper 4 Ocober, 2 28 4

The Border o Macro and Finance ASSET PRICING APPLICATIONS Lucas-ree model General equilibrium asse pricing Equiy premium puzzle Risk-ree rae puzzle Alernaive preerence speciicaions Recursive uiliy (Epsein-Zin Habi persisence Hyperbolic discouning Risk sharing Aggregaion (Consrucing he represenaive consumer Ocober, 2 29 5