Asset pricing under uncertainty about shock propagation

Nicole Branger, Patrick Grüning, Holger Kraft and Christoph Meinerding

No 34, SAFE Working Paper Series from Leibniz Institute for Financial Research SAFE

Abstract: We analyze the equilibrium in a two-tree (sector) economy with two regimes. The output of each tree is driven by a jump-diffusion process, and a downward jump in one sector of the economy can (but need not) trigger a shift to a regime where the likelihood of future jumps is generally higher. Furthermore, the true regime is unobservable, so that the representative Epstein-Zin investor has to extract the probability of being in a certain regime from the data. These two channels help us to match the stylized facts of countercyclical and excessive return volatilities and correlations between sectors. Moreover, the model reproduces the predictability of stock returns in the data without generating consumption growth predictability. The uncertainty about the state also reduces the slope of the term structure of equity. We document that heterogeneity between the two sectors with respect to shock propagation risk can lead to highly persistent aggregate price-dividend ratios. Finally, the possibility of jumps in one sector triggering higher overall jump probabilities boosts jump risk premia while uncertainty about the regime is the reason for sizeable diffusive risk premia.

Keywords: General Equilibrium; Contagion Risk; Partial Information; Filtering; Recursive Utility (search for similar items in EconPapers)
JEL-codes: G01 G12 (search for similar items in EconPapers)
Date: 2013
New Economics Papers: this item is included in nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:safewp:34

DOI: 10.2139/ssrn.2360455

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