Rare Events, Financial Crises, and the Cross-Section of Asset Returns

Francesco Bianchi

No 10-40, Working Papers from Duke University, Department of Economics

Abstract: This paper shows that rare events are important in explaining the cross section of asset returns because of their role in shaping agents' expectations. I reconsider the "bad beta, good beta" ICAPM proposed by Campbell and Vuolteenaho and I point out that the explanatory power of the model relies on including the stock market crash that opened the Great Depression. When using a Markov-switching VAR, a '30s regime is identified. This regime receives a large weight when forming expectations consistent with the ICAPM, suggesting that the way agents think about financial markets is shaped by what happens during extreme circumstances. From a technical point of view, the paper extends the present value decomposition of Campbell and Shiller to allow for Markov-switching dynamics in the law of motion of the state variables. This approach could shed new light on the sensitivity of the present value decomposition methodology to the sample choice.

Pages: 46
Date: 2010
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Citations: View citations in EconPapers (7)

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Related works:
Working Paper: Rare Events, Financial Crises, and the Cross-Section of Asset Returns (2015)
Working Paper: Rare Events, Financial Crises, and the Cross-Section of Asset Returns (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:duk:dukeec:10-40

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