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Dynamic Equilibrium with Rare Events and Heterogeneous Epstein-Zin InvestorsGeorgy ChabakauriLondon School of Economics and Political Science January 10, 2015 Abstract: We consider a general equilibrium Lucas (1978) economy with one consumption good and two heterogeneous Epstein-Zin investors. The output is subject to rare large drops or, more generally, can have non-lognormal distribution with higher cumulants. The heterogeneity in preferences generates excess stock return volatilities, procyclical price-dividend ratios and interest rates, and countercyclical market prices of risk when the elasticity of intertemporal substitution (EIS) is greater than one. Moreover, the latter results cannot be jointly replicated in a model where investors have EIS<1 or CRRA preferences. We propose new approach for deriving equilibrium, and extend the analysis to the case of heterogeneous beliefs about probabilities of rare events.
Number of Pages in PDF File: 35 Keywords: heterogeneous investors, Epstein-Zin preferences, rare events, equilibrium, portfolio choice JEL Classification: D53, G11, G12 Date posted: April 8, 2014 ; Last revised: January 11, 2015Suggested CitationContact Information
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