Valuation Risk Revalued

23 Pages Posted: 3 Aug 2018 Last revised: 19 Aug 2018

Oliver de Groot

University of St. Andrews - School of Economics and Finance

Alexander Richter

Federal Reserve Bank of Dallas

Nathaniel Throckmorton

College of William and Mary - Department of Economics

Date Written: 2018-07-20

Abstract

The recent asset pricing literature finds valuation risk is an important determinant of key asset pricing moments. Valuation risk is modelled as a time preference shock within Epstein-Zin recursive utility preferences. While this form of valuation risk appears to fit the data extremely well, we show the preference specification violates an economically meaningful restriction on the weights in the Epstein-Zin time-aggregator. The same model with the corrected preference specification performs nearly as well at matching asset pricing moments, but only if the risk aversion parameter is well above the accepted range of values used in the literature. When the corrected preference specification is combined with Bansal-Yaron long-run risk, the estimated model significantly downgrades the role of valuation risk in determining asset prices. The only significant contribution of valuation risk is to help match the volatility of the risk-free rate.

Keywords: Epstein-Zin Utility, Valuation Risk, Equity Premium Puzzle, Risk-Free Rate Puzzle

JEL Classification: D81, G12

Suggested Citation

de Groot, Oliver and Richter, Alexander and Throckmorton, Nathaniel, Valuation Risk Revalued (2018-07-20). FRB of Dallas Working Paper No. 1808. Available at SSRN: https://ssrn.com/abstract=3225736 or http://dx.doi.org/10.24149/wp1808

Oliver De Groot (Contact Author)

University of St. Andrews - School of Economics and Finance ( email )

The Scores, Castlecliff
St. Andrews, Fife KY16 8RD
United Kingdom

Alexander Richter

Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5360 (Phone)

HOME PAGE: http://alexrichterecon.com

Nathaniel Throckmorton

College of William and Mary - Department of Economics ( email )

Williamsburg, VA 23187-8795
United States

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