Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM

CREATES Research Paper No. 2012-32

45 Pages Posted: 10 Jul 2012  

Olaf Posch

Universit├Ąt Hamburg, Department of Economics; CREATES

Andreas Schrimpf

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

Date Written: July 1, 2012

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.

Keywords: euler equation errors, rare disasters, C-CAPM

JEL Classification: E21, G12, O41

Suggested Citation

Posch, Olaf and Schrimpf, Andreas, Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM (July 1, 2012). CREATES Research Paper No. 2012-32. Available at SSRN: https://ssrn.com/abstract=2103070 or http://dx.doi.org/10.2139/ssrn.2103070

Olaf Posch (Contact Author)

Universit├Ąt 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

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

Centralbahnplatz 2
CH-4002 Basel
Switzerland

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