Non-Falsified Expectations and General Equilibrium Asset Pricing: The Power of the Peso

CEPR Discussion Paper No. 1819

Posted: 20 Aug 1998

See all articles by Jean-Pierre Danthine

Jean-Pierre Danthine

University of Lausanne - Institute of Banking and Finance (IBF); Centre for Economic Policy Research (CEPR); Swiss Finance Institute

John B. Donaldson

Columbia Business School - Finance and Economics

Date Written: March 1998

Abstract

We discuss the extent to which the expectation of a rare event, not present in the usual post-war sample data, "the peso problem" can affect the behaviour of rational agents and the characteristics of market equilibrium. To that end, we describe quantitatively the macroeconomic and financial properties of a standard equilibrium business cycle model, modified to allow for a very small probability of a depression state. We are careful to contrast what would be the stationary probability distribution descriptive of the dynamic rational expectations (RE) equilibrium, from the empirically observed behaviour of the economy under the same RE assumption when the depression does not appear in the sample. The effects of small probability events appear to be especially significant for financial market characteristics. We produce a reasonable model specification, for which both business cycle characteristics and mean financial returns are in accord with US observations. The 6.2% premium is obtained in an economy where agents are only moderately risk averse and where there are no frictions.

JEL Classification: D84. E32. G12

Suggested Citation

Danthine, Jean-Pierre and Donaldson, John B., Non-Falsified Expectations and General Equilibrium Asset Pricing: The Power of the Peso (March 1998). CEPR Discussion Paper No. 1819, Available at SSRN: https://ssrn.com/abstract=106348

Jean-Pierre Danthine (Contact Author)

University of Lausanne - Institute of Banking and Finance (IBF) ( email )

Lausanne, 1015
Switzerland
+41 21 692 3485 (Phone)
+41 21 692 3335 (Fax)

HOME PAGE: http://www.hec.unil.ch/jdanthine/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

John B. Donaldson

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

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