Dynamic Equilibrium with Rare Events and Heterogeneous Epstein-Zin Investors

Abstract

We consider a general equilibrium Lucas (1978) economy with one consumption good and two heterogeneous Epstein-Zin investors. The output is subject to rare large drops or, more generally, can have non-lognormal distribution with higher cumulants. The heterogeneity in preferences generates excess stock return volatilities, procyclical price-dividend ratios and interest rates, and countercyclical market prices of risk when the elasticity of intertemporal substitution (EIS) is greater than one. Moreover, the latter results cannot be jointly replicated in a model where investors have EIS<1 or CRRA preferences. We propose new approach for deriving equilibrium, and extend the analysis to the case of heterogeneous beliefs about probabilities of rare events.

Keywords: heterogeneous investors, Epstein-Zin preferences, rare events, equilibrium, portfolio choice

JEL Classification: D53, G11, G12