Working Paper: CEPR ID: DP16299
Authors: Juan Carlos Parra-Alvarez; Olaf Posch; Andreas Schrimpf
Abstract: This paper shows that the consumption-based capital asset pricing model (C-CAPM) with low-probability disaster risk rationalizes pricing errors. We find that implausible estimates of risk aversion and time preference are not puzzling if market participants expect a future catastrophic change in fundamentals, which just happens not to occur in the sample (a ‘peso problem’). A bias in structural parameter estimates emerges as a result of pricing errors in quiet times. While the bias essentially removes the pricing error in the simple models when risk-free rates are constant, time-variation may also generate large and persistent estimated pricing errors in simulated data. We also showanalytically how the problem of biased estimates can be avoided in empirical research by resolving the misspecification in moment conditions.
Keywords: rare events; asset pricing errors; CCAPM
JEL Codes: E21; G12; O41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| rare disaster risk (H84) | pricing errors (D49) |
| expectations of rare events (D84) | biased parameter estimates (C51) |
| absence of rare disasters in the sample (H84) | misestimation of risk aversion and time preference parameters (D15) |
| GMM estimation method (without disasters) (C51) | biased estimates (C51) |