Working Paper: NBER ID: w3752
Authors: Stephen G. Cecchetti; P0ksang Lam; Nelson C. Mark
Abstract: This paper investigates the ability of a representative agent model with time separable utility to explain the mean vector and the covariance matrix of the risk free interest rate and the return to leveraged equity in the stock market. The paper generalizes the standard calibration methodology by accounting for the uncertainty in both the sample moments to be explained and the estimated parameters to which the model is calibrated. We develop a testing framework to evaluate the model's ability to match the moments of the data. We study two forms of the model, both of which treat leverage in a manner consistent with the data. In the first, dividends explicitly represent the flow that accrues to the owner of the equity, and they are discounted by the marginal rate of intertemporal substitution defined over consumption. The second form of the model introduces bonds and treats equities as the residual claim to the total endowment stream. We find that the first moments of the data can be matched for a wide range of preference parameter values. But for both models the implied first and second moments taken together are always statistically significantly different from the data at standard levels. This last result contrasts sharply with other recent treatments of leverage in the literature.
Keywords: equity premium; risk-free rate; representative agent model; leverage; calibration
JEL Codes: G12; E43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| representative agent model (E13) | explain dynamics of asset prices (G19) |
| representative agent model (E13) | match first moments of the data (C51) |
| leverage aspect of equities (G12) | partially explain moments (Y60) |
| model's inability to match second moments (C52) | requires inconsistent quantity of bonds (G12) |
| implied moments (Y20) | statistically significantly different from observed moments (C52) |