Rational Pessimism, Rational Exuberance, and Asset Pricing Models

45 Pages Posted: 27 Jun 2007 Last revised: 9 Aug 2007

See all articles by Ravi Bansal

Ravi Bansal

Duke University and NBER

A. Ronald Gallant

Duke University - Fuqua School of Business, Economics Group; New York University - Department of Economics

George Tauchen

Duke University - Economics Group

Date Written: May 2007

Abstract

The paper estimates and examines the empirical plausibiltiy of asset pricing models that attempt to explain features of financial markets such as the size of the equity premium and the volatility of the stock market. In one model, the long run risks model of Bansal and Yaron (2004), low frequency movements and time varying uncertainty in aggregate consumption growth are the key channels for understanding asset prices. In another, as typified by Campbell and Cochrane (1999), habit formation, which generates time-varying risk-aversion and consequently time-variation in risk-premia, is the key channel. These models are fitted to data using simulation estimators. Both models are found to fit the data equally well at conventional significance levels, and they can track quite closely a new measure of realized annual volatility. Further scrutiny using a rich array of diagnostics suggests that the long run risk model is preferred.

Suggested Citation

Bansal, Ravi and Gallant, A. Ronald and Tauchen, George E., Rational Pessimism, Rational Exuberance, and Asset Pricing Models (May 2007). NBER Working Paper No. w13107. Available at SSRN: https://ssrn.com/abstract=986957

Ravi Bansal (Contact Author)

Duke University and NBER ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7758 (Phone)
919-660-8038 (Fax)

A. Ronald Gallant

Duke University - Fuqua School of Business, Economics Group ( email )

Box 90097
Durham, NC 27708-0097
United States

New York University - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States

George E. Tauchen

Duke University - Economics Group ( email )

Box 90097
221 Social Sciences
Durham, NC 27708-0097
United States
919-660-1812 (Phone)
919-684-8974 (Fax)

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