Asset Pricing in a Production Economy with Chew-Dekel Preferences

Leonard N. Stern Economics Working Paper

43 Pages Posted: 17 May 2007

See all articles by Claudio Campanale

Claudio Campanale

Universidad de Alicante - Faculty of Economic and Business 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)

Multiple version iconThere are 2 versions of this paper

Date Written: May 1, 2007

Abstract

In this paper we provide a thorough characterization of the asset return implied by a simple general equilibrium production economy with convex investment adjustment costs. When households have Epstein-Zin preferences, 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 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. Given the work of Rabin (2000) among others, it is not surprising that our Epstein-Zin agent exhibits a much higher risk aversion when faced with substantially larger risks. This shortcoming, however, does not extend to the case in which agents are disappointment averse in the sense of Gul (1991). When 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, Business Cycle, Predictability, Disappointment Aversion

JEL Classification: D81, E32, E43, E44, G12.

Suggested Citation

Campanale, Claudio and Castro, Rui and Clementi, Gian Luca, Asset Pricing in a Production Economy with Chew-Dekel Preferences (May 1, 2007). Leonard N. Stern Economics Working Paper. Available at SSRN: https://ssrn.com/abstract=986628 or http://dx.doi.org/10.2139/ssrn.986628

Claudio Campanale

Universidad de Alicante - Faculty of Economic and Business Sciences ( email )

Germán Edifcio Bernácer - Ground floor
Campus of San Vicente del Raspeig
Alicante, 03080
Spain

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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