Peso Problems in the Estimation of the C-CAPM

Quantitative Economics (accepted for publication)

56 Pages Posted: 10 Jul 2012 Last revised: 24 Jun 2021

See all articles by Juan Carlos Parra-Alvarez

Juan Carlos Parra-Alvarez

Aarhus University - CREATES

Olaf Posch

Universität Hamburg, Department of Economics; CREATES

Andreas Schrimpf

Bank for International Settlements (BIS) - Monetary and Economic Department; CREATES - Aarhus University

Date Written: March 2021

Abstract

This paper shows that the consumption-based capital asset pricing model (C-CAPM) with low-probability disaster risk rationalizes pricing errors. We find that implausible estimates of risk aversion and time preference are not puzzling if market participants expect a future catastrophic change in fundamentals, which just happens not to occur in the sample (a ‘peso problem’). A bias in structural parameter estimates emerges as a result of rational pricing errors in quiet times. While the bias essentially removes the pricing error in the simple models with constant risk-free rates, time-variation may also generate large and persistent estimated pricing errors in simulated data. We also show analytically how the problem of biased estimates can be avoided in empirical research by resolving the misspecification in moment conditions.

Keywords: Rare disasters, Asset pricing errors, C-CAPM

JEL Classification: E21, G12, O41

Suggested Citation

Parra-Alvarez, Juan Carlos and Posch, Olaf and Schrimpf, Andreas and Schrimpf, Andreas, Peso Problems in the Estimation of the C-CAPM (March 2021). Quantitative Economics (accepted for publication), Available at SSRN: https://ssrn.com/abstract=2103070 or http://dx.doi.org/10.2139/ssrn.2103070

Juan Carlos Parra-Alvarez

Aarhus University - CREATES ( email )

Department of Economics and Business
Fuglesangs Allé 4
Aarhus V, 8210
Denmark

Olaf Posch (Contact Author)

Universität Hamburg, Department of Economics ( email )

Von-Melle-Park 5
Hamburg, 20146
Germany

CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Andreas Schrimpf

CREATES - Aarhus University ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

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