Macro-finance MT Flashcards
What do we require of the correlation between the stochastic discount factor and the interest rate to explain the equity premium puzzle?
Why is this not realistic?
Strongly negative
Means r expected to be high when ct+1 high compared to ct
Would like stocks to provide insurance ie high payoffs at times of low consumption
Not realistic because stock returns are positively correlated with the business cycle so would need to pay high excess return for households to hold them
3 approaches to reconcile macro and financial variables
- Exotic preferences (habits, EZ)
- Disaster risk
- Subjective belief/ learning models
Fundamental asset pricing equation
Et(stochastic discount factor x rt+1)=1
Results of the habits model
Get sizeable equity premium which is good
Get very volatile risk free rate which is not good
Get negative autocorrelation in equity return which is not good
Recursive utility models
Separate risk aversion from elasticity of substitution
Eg. EZ 1989 and 91
Results of Epstein-Zin preferences
Match equity premium
No risk-free rate puzzle
Small estimated elasticity of substitution
Not statistically different from log specification of risk preferences
Problem: Rate of time preference often significantly negative
To work well, EZ needs
(small) predictable component in consumption and dividend growth
time-varying volatility (capturing economic uncertainty)
EZ in GE
Risk preferences improve compared to habits
Can match macro and financial moments
Less successful with nominal variables
Not fully in line with quantitative findings especially in production setups
Problems with risk free rate predictions for
CRRA Euler
Internal Habits
Recursive preferences
CRRA is wrong level and moves opposite to reality
Far too volatile in internal habits
Recursive matches volatility but negative correlation between predictions and data!
Disaster risk:
Euler
Capital
Add exogenous w risk to Euler
Difference between chosen and actual capital
Disaster impact
Large fall in productivity and capital, fall in labour demand despite wealth effect on labour supply
Investment becomes riskier
Output and cons keep falling whilst in disaster state
Recover to lower trend growth rate so permanent effect
Real interest rate falls until disaster over
Stock prices drop a lot but recover quickly
