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Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPMOlaf PoschUniversität Hamburg, Department of Economics; CREATES Andreas SchrimpfBank for International Settlements (BIS) - Monetary and Economic Department July 1, 2012 CREATES Research Paper No. 2012-32 Abstract: This paper shows that the consumption-based asset pricing model (C-CAPM) with low-probability disaster risk rationalizes large pricing errors, i.e., Euler equation errors. This result is remarkable, since Lettau and Ludvigson (2009) show that leading asset pricing models cannot explain sizeable pricing errors in the C-CAPM. We also show (analytically and in a Monte Carlo study) that implausible estimates of risk aversion and time preference are not puzzling in this framework and emerge as a result of rational pricing errors. While this bias essentially removes the pricing error in the traditional endowment economy, a production economy with stochastically changing investment opportunities generates large and persistent empirical pricing errors.
Number of Pages in PDF File: 45 Keywords: euler equation errors, rare disasters, C-CAPM JEL Classification: E21, G12, O41 working papers seriesDate posted: July 10, 2012Suggested CitationContact Information
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