Getting Paranoid When Disasters Strike: A Learning-Based Explanation for Asset Pricing Puzzles

62 Pages Posted: 16 Mar 2012

See all articles by Redouane Elkamhi

Redouane Elkamhi

University of Toronto - Rotman School of Management

Du Du

Hong Kong University of Science & Technology (HKUST)

Date Written: November 15, 2011

Abstract

This article studies the pricing implications of learning about arrivals of economic disasters and the subsequent recoveries. We model a disaster as a separate phase, and transitions between the disaster and the normal phase introduce structual changes to the consumption process which triggers jumps in the equity market, a concern for a representative agent with recursive utillity. Learning creates a positive covariance between the expected arrivals of future events (either disaster or recovery) and their actual realizations. In particular, the agent becomes more pessimistic (optimistic) the moment a disaster (recovery) occurs. The positive covariance generates the extra learning-induced compensation for jump risks which proves helpful to understanding various asset return puzzles.

Suggested Citation

Elkamhi, Redouane and Du, Du, Getting Paranoid When Disasters Strike: A Learning-Based Explanation for Asset Pricing Puzzles (November 15, 2011). Available at SSRN: https://ssrn.com/abstract=2023091 or http://dx.doi.org/10.2139/ssrn.2023091

Redouane Elkamhi (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Du Du

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

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