The CAPM Strikes Back? An Equilibrium Model with Disasters
64 Pages Posted: 7 Mar 2018
Date Written: February 28, 2018
Embedding disasters into a general equilibrium model with heterogeneous firms induces strong nonlinearity in the pricing kernel, helping explain the empirical failure of the (consumption) CAPM. Our single-factor model reproduces the failure of the CAPM in explaining the value premium in finite samples without disasters, and its relative success in samples with disasters. Due to beta measurement errors, the estimated beta-return relation is flat, consistent with the beta “anomaly,” even though the true beta-return relation is strongly positive. Finally, the consumption CAPM fails in simulations, even though a nonlinear model with the true pricing kernel holds exactly by construction.
Keywords: The CAPM, Rare Disasters, Measurement Errors, The Consumption CAPM, General Equilibrium, Approximate Aggregation
JEL Classification: G12, G14
Suggested Citation: Suggested Citation