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
Date Written: March 2021
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: Suggested Citation