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Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM

Olaf Posch () and Andreas Schrimpf

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: This paper shows that the consumption-based asset pricing model (C-CAPM) with low-probability disaster risk rationalizes large pricing errors, i.e. Euler equation errors. This result is remarkable, since Lettau and Ludvigson (2009) show that leading asset pricing models cannot explain sizeable pricing errors in the C-CAPM. We also show (analytically and in a Monte Carlo study) that implausible estimates of risk aversion and time preference are not puzzling in this framework and emerge as a result of rational pricing errors. While this bias essentially removes the pricing error in the traditional endowment economy, a production economy with stochastically changing investment opportunities generates large and persistent empirical pricing errors.

Keywords: Euler equation errors; Rare disasters; C-CAPM (search for similar items in EconPapers)
JEL-codes: E21 G12 O41 (search for similar items in EconPapers)
Pages: 45
Date: 2012-07-11
New Economics Papers: this item is included in nep-mac and nep-upt
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https://repec.econ.au.dk/repec/creates/rp/12/rp12_32.pdf (application/pdf)

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Working Paper: Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM (2013) Downloads
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