Disaster - DO DISASTER EXPECTATIONS EXPLAIN HOUSEHOLD...

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Unformatted text preview: DO DISASTER EXPECTATIONS EXPLAIN HOUSEHOLD PORTFOLIOS? 1 Sule Alan Faculty of Economics and CFAP University of Cambridge Cambridge, United Kingdom E-mail: sule.alan@econ.cam.ac.uk December 2008 1 I thank Thomas Crossley, Hamish Low and seminar participants at the University of Cambridge and University College London for valuable comments and suggestions. I also thank Ruxandra Dumitrescu for excellent research assistance. This research is partly funded by the Center for Financial Analysis and Policy (CFAP). Abstract It has been argued that rare economic disasters can explain most asset pricing puzzles. If this is the case, perceived risk associated with a disaster in stock markets should be revealed in household portfolios. That is, the framework that solves these pricing puzzles should also generate quantities that are consistent with the observed ones. This paper estimates the perceived risk of disasters (both probability and expected size) that is consistent with observed portfolios and consumption growth between 1983 and 2004 in the United States. I &nd that the disaster probabilities that justify life cycle pro&les of stock market participation, equity shares and consumption growth are in the neighborhood of 4 percent per year. The estimated disaster probabilities vary across cohorts without any systematic pattern. Older cohorts expect such &nancial disasters to be more devastating. I also &nd that participation costs are not needed to match observed participation pro&les once disaster expectations are allowed. 1 Introduction Following Mehra and Prescott &s seminal 1985 article, a large body of research has ac- cumulated which proposes solutions to the "equity premium puzzle." Various strands of the literature consider preference re-specications (Campbell and Cochrane (1999), Bansal and Yaron (2004)), market frictions and preference heterogeneity (Constan- tinides et al. (2002)), and model uncertainty (Weitzman (2008)). An alternative strand of the literature emphasizes the limitations of the post-war historical return data. The observed equity premium can be rationalized if the standard model takes into account the possibility of rare but disastrous market events (such as occurred before the post-war period). This idea was rst proposed by Reitz (1988) and ex- tended by Barro (2006) and Barro and Ursua (2008). Barro (2006) analyses 20th century disasters using GDP and stock market data from 35 countries. He suggests that a disaster probability of 1 : 5 & 2 percent a year, with an associated decline in per capita GDP of 15 & 64 percent from peak to trough, goes a long way in explaining the equity premium puzzle. In follow up work using aggregate consumption data from 21 countries, Barro and Ursua ( 2008) calibrate the disaster probability to 3 : 6 percent a year with an associated 22 percent decline in consumption from peak to trough....
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This note was uploaded on 04/29/2010 for the course ECON 345 taught by Professor Sumaila during the Fall '09 term at The University of British Columbia.

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Disaster - DO DISASTER EXPECTATIONS EXPLAIN HOUSEHOLD...

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