Identification of Beliefs in the Presence of Disaster Risk and Misspecification

Saraswata Chaudhuri, Eric Renault and Oscar Wahlstrom

A chapter in Essays in Honor of Joon Y. Park: Econometric Methodology in Empirical Applications, 2023, vol. 45B, pp 261-290 from Emerald Group Publishing Limited

Abstract: The authors discuss the econometric underpinnings ofBarro (2006)'s defense of the rare disaster model as a way to bring back an asset pricing model “into the right ballpark for explaining the equity-premium and related asset-market puzzles.” Arbitrarily low-probability economic disasters can restore the validity of model-implied moment conditions only if the amplitude of disasters may be arbitrary large in due proportion. The authors prove an impossibility theorem that in case of potentially unbounded disasters, there is no such thing as a population empirical likelihood (EL)-based model-implied probability distribution. That is, one cannot identify some belief distortions for which the EL-based implied probabilities in sample, as computed byJulliard and Ghosh (2012), could be a consistent estimator. This may lead to consider alternative statistical discrepancy measures to avoid the problem with EL. Indeed, the authors prove that, under sufficient integrability conditions, power divergence Cressie-Read measures with positive power coefficients properly define a unique population model-implied probability measure. However, when this computation is useful because the reference asset pricing model is misspecified, each power divergence will deliver different model-implied beliefs distortion. One way to provide economic underpinnings to the choice of a particular belief distortion is to see it as the endogenous result of investor's choice when optimizing a recursive multiple-priors utilityalaChen and Epstein (2002).Jeong et al. (2015)'s econometric study confirms that this way of accommodating ambiguity aversion may help to address the Equity Premium puzzle.

Keywords: Asset pricing; beliefs distortion; disaster risk; misspecification; empirical likelihood; equity premium puzzle (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:eme:aecozz:s0731-90532023000045b012

DOI: 10.1108/S0731-90532023000045B012

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