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Valuation Risk Revalued

Oliver de Groot, Alexander Richter () and Nathaniel Throckmorton

No 1808, Working Papers from Federal Reserve Bank of Dallas

Abstract: The recent asset pricing literature finds valuation risk is an important determinant of key asset pricing moments. Valuation risk is modelled as a time preference shock within Epstein-Zin recursive utility preferences. While this form of valuation risk appears to fit the data extremely well, we show the preference specification violates an economically meaningful restriction on the weights in the Epstein-Zin time-aggregator. The same model with the corrected preference specification performs nearly as well at matching asset pricing moments, but only if the risk aversion parameter is well above the accepted range of values used in the literature. When the corrected preference specification is combined with Bansal-Yaron long-run risk, the estimated model significantly downgrades the role of valuation risk in determining asset prices. The only significant contribution of valuation risk is to help match the volatility of the risk-free rate.

Keywords: Epstein-Zin Utility; Valuation Risk; Equity Premium Puzzle; Risk-Free Rate Puzzle (search for similar items in EconPapers)
JEL-codes: D81 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-rmg and nep-upt
Date: 2018-07-20
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DOI: 10.24149/wp1808

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