Equity Prices Under Bayesian Doubt About Macroeconomic Fundamentals

Michal Pakos

No 2008-E42, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: I present a consumption-based explanation of a number of phenomena in the aggregate equity market. The model invokes the recursive utility function of Epstein and Zin (1989), configured with the plausible parameters of the average coefficient of the aversion to late resolution of uncertainty of about 22, and the elasticity of intertemporal substitution of 1.5. Statistically hard to discriminate in less than 80 years of data from the ubiquitous model of real consumption growth, the endowment process is specified as being subject to sporadic large shocks and incessant small shocks. The large infrequent shocks, modelled by means of a four-state hidden Markov chain, display interesting macroeconomic regularities, occuring at both the business-cycle, and a lower, frequencies. Despite the fact that the levels of endowments are observable, the source of their variation cannot be detected perfectly, facing investors with a complex signal-extraction problem. The associated posterior probabilities provide a natural link between the observed asset value fluctuations and the economic uncertainty within the rational Bayesian learning framework. Although computationally arduous, having to be solved on a high-performance computing machine in a low-level language, the model is able to account for (i) the observed magnitude of the equity premium, (ii) the low and stable risk-free rate, (iii) the magnitude and the countercyclicality of risk prices, (iv) the average levels and the procyclicality of price-dividend and wealth-consumption ratios, (v) the long-horizon predictability of risk premia, and (vi) the overreaction of price-dividend ratio to bad news in good times, all within the conceptually simple representative-agent framework.

Date: 2008-11
References: Add references at CitEc
Citations:

Downloads: (external link)
https://student-3k.tepper.cmu.edu/gsiadoc/wp/2008-E42.pdf
Our link check indicates that this URL is bad, the error code is: 401 Unauthorized

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cmu:gsiawp:1226145652

Ordering information: This working paper can be ordered from
https://student-3k.t ... /gsiadoc/GSIA_WP.asp

Access Statistics for this paper

More papers in GSIA Working Papers from Carnegie Mellon University, Tepper School of Business Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213-3890.
Bibliographic data for series maintained by Steve Spear ().