Dynamic Equilibrium with Rare Events and Heterogeneous Epstein-Zin Investors
35 Pages Posted: 8 Apr 2014 Last revised: 11 Jan 2015
Date Written: January 10, 2015
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.
Keywords: heterogeneous investors, Epstein-Zin preferences, rare events, equilibrium, portfolio choice
JEL Classification: D53, G11, G12
Suggested Citation: Suggested Citation