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Asset Pricing Under Uncertainty About Shock Propagation

SAFE Working Paper No. 34

67 Pages Posted: 28 Nov 2013 Last revised: 25 Mar 2014

Nicole Branger

University of Muenster - Finance Center Muenster

Patrick Grüning

Bank of Lithuania - CEFER; Vilnius University - Faculty of Economics; Research Center SAFE

Holger Kraft

Goethe University Frankfurt

Christoph Meinerding

Deutsche Bundesbank

Christian Schlag

Goethe University Frankfurt - Research Center SAFE

Date Written: November 18, 2013

Abstract

We analyze the equilibrium in a two-tree (sector) economy with two regimes. The output of each tree is driven by a jump-diffusion process, and a downward jump in one sector of the economy can (but need not) trigger a shift to a regime where the likelihood of future jumps is generally higher. Furthermore, the true regime is unobservable, so that the representative Epstein-Zin investor has to extract the probability of being in a certain regime from the data. These two channels help us to match the stylized facts of countercyclical and excessive return volatilities and correlations between sectors. Moreover, the model reproduces the predictability of stock returns in the data without generating consumption growth predictability. The uncertainty about the state also reduces the slope of the term structure of equity. We document that heterogeneity between the two sectors with respect to shock propagation risk can lead to highly persistent aggregate price-dividend ratios. Finally, the possibility of jumps in one sector triggering higher overall jump probabilities boosts jump risk premia while uncertainty about the regime is the reason for sizeable diffusive risk premia.

Keywords: General Equilibrium, Contagion Risk, Partial Information, Filtering, Recursive Utility

JEL Classification: G01, G12

Suggested Citation

Branger, Nicole and Grüning, Patrick and Kraft, Holger and Meinerding, Christoph and Schlag, Christian, Asset Pricing Under Uncertainty About Shock Propagation (November 18, 2013). SAFE Working Paper No. 34. Available at SSRN: https://ssrn.com/abstract=2360455 or http://dx.doi.org/10.2139/ssrn.2360455

Nicole Branger

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 29779 (Phone)
+49 251 83 22867 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=162

Patrick Grüning

Bank of Lithuania - CEFER ( email )

Totoriu g. 4
Vilnius, LT-01121
Lithuania
+370 5 2680 069 (Phone)

HOME PAGE: http://https://www.lb.lt/cefer

Vilnius University - Faculty of Economics ( email )

Sauletekio al. 9 (II building)
Vilnius, LT-10222
Lithuania

HOME PAGE: http://www.ef.vu.lt/

Research Center SAFE ( email )

Goethe University Frankfurt
Theodor-W.-Adorno Platz 3
Frankfurt am Main, D-60629
Germany

HOME PAGE: http://safe-frankfurt.de/research/all-researchers/details/showauthor/patrick-gruening.html

Holger Kraft

Goethe University Frankfurt ( email )

Faculty of Economics and Business Administration
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Christoph Meinerding (Contact Author)

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Christian Schlag

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany
+49 69 798 33699 (Phone)
+49 69 798 33901 (Fax)

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