Consumption-Based Asset Pricing with Rare Disaster Risk - A Simulated Method of Moments Approach

Abstract

We 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, we find that the estimates of the investor preference parameters and the model-implied equity premium, mean risk-free rate, and market Sharpe ratio are perfectly 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 consumption-based asset pricing approach.

Keywords: equity premium, rare disaster risk, asset pricing, simulated method of moments

JEL Classification: G10, G12, C58