Consumption-Based Asset Pricing with Rare Disaster Risk - A Simulated Method of Moments Approach
52 Pages Posted: 18 Feb 2014 Last revised: 4 Oct 2018
Date Written: September 26, 2018
We propose a simulated method of moments strategy to estimate a consumption-based asset pricing model (CBM) that accounts for the possibility of severe economic contractions, thereby providing a test of the rare disaster hypothesis and a re-evaluation of the empirical performance of the canonical CBM. Unlike in previous studies, the estimates of the investor preference parameters and the model-implied equity premium, mean risk-free rate, and market Sharpe ratio are economically plausible and precise. Accounting for rare disasters thus helps to restore the nexus between financial markets and the real economy that is implied by the CBM.
Keywords: rare disaster hypothesis, simulated method of moments, consumption-based asset pricing
JEL Classification: C58, G12
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