Asset Pricing in a General Equilibrium Production Economy With Chew-Dekel Risk Preferences

43 Pages Posted: 6 Mar 2007

See all articles by Claudio Campanale

Claudio Campanale

University of Rochester - School of Arts and Sciences

Rui Castro

McGill University - Department of Economics

Gian Luca Clementi

New York University - Leonard N. Stern School of Business; National Bureau of Economic Research (NBER); University of Bologna - Rimini Center for Economic Analysis (RCEA)

Date Written: March 2, 2007

Abstract

In this paper we provide a thorough characterization of the asset returns implied by a simple general equilibrium production economy with convex investment adjustment costs. When households have Epstein-Zin references, there exist plausible parameter values such that the model generates unconditional mean risk-free rate and equity return, and volatility of consumption growth, which are in line with historical averages for the US economy. Consistently with the data, the model's implied price-dividend ratio is pro-cyclical and stock returns are predictable (and increasingly so as the time horizon increases), while dividend growth is not. The model also implies realistic values for (i) the correlation of the risk-free rate with output growth and consumption growth and (ii) the correlation pattern between risk-free rate, equity return, and equity premium. The risk implied by the model is rather low. At the modal state of nature, an individual that expects to consume for 100,000 dollars a year faces a lottery over future consumption with a standard deviation of 55 dollars (per quarter). Her risk aversion is such that she's willing to pay 1 dollar (per quarter) in order to avoid that lottery. Very similar results can be obtained assuming that agents are disappointment averse in the sense of Gul. With such risk preferences, the universality requirement is not a problem to the extent that it is in the case of expected utility. In fact, faced with a lottery that has a coefficient of variation 100 times as large as that implied by our model, a disappointment averse agent displays the same relative risk aversion as an expected utility agent with logarithmic utility.

Keywords: Equity Premium, disappointment aversion, predictability, business cycle

JEL Classification: G12, D81, E44

Suggested Citation

Campanale, Claudio and Castro, Rui and Clementi, Gian Luca, Asset Pricing in a General Equilibrium Production Economy With Chew-Dekel Risk Preferences (March 2, 2007). Available at SSRN: https://ssrn.com/abstract=967789 or http://dx.doi.org/10.2139/ssrn.967789

Claudio Campanale

University of Rochester - School of Arts and Sciences ( email )

Rochester, NY 14627
United States

Rui Castro

McGill University - Department of Economics ( email )

855 Sherbrooke Street West
Montreal, QC H3A 2T7
CANADA

Gian Luca Clementi (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

44 W Fourth Street
New York, NY 10012
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Bologna - Rimini Center for Economic Analysis (RCEA) ( email )

Via Patara, 3
Rimini (RN), RN 47900
Italy

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