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

Bianchi, Francesco (2008): Rare Events, Financial Crises, and the Cross-Section of Asset Returns.

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Markov-switching, Rare Events, Bayesian, Asset Pricing
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G0 - General > G01 - Financial Crises; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C11 - Bayesian Analysis: General

References

Barro, R.: 2009, Rare disasters, asset prices, and welfare costs, The American Economic Review 99(1).

Barro, R. J.: 2006, Rare disasters and asset markets in the twentieth century, Quarterly Journal of Economics 121, 823-�866.

Barro, R., Nakamura, E., Steinsson, J. and Ursúa, J.: 2009, Crises and recoveries in a model of consumption disasters, Columbia University, working paper.

Bianchi, F.: 2003, The betas and the risk premium: An econometric investigation, Bocconi University undergraduate dissertation.

Bianchi, F.: 2010, The Great depression and the Great recession: A view from the stock market (working title), Duke University, working paper.

Bianchi, F., Mumtaz, H. and Surico, P.: 2009, The Great moderation of the term structure of U.K. interest rates, Journal of Monetary Economics 56, 856-�871.

Campbell, J. Y.: 1991, A variance decomposition for stock returns, Economic Journal 101(405), 157-�179.

Campbell, J. Y., Polk, C. and Vuolteenaho, T.: 2007, Growth or glamour? Fundamentals and systematic risk in stock returns, Review of Financial Studies 23, 305�-344.

Campbell, J. Y. and Shiller, R. J.: 1988, Interpreting cointegrated models, Journal of Economic Dynamics and Control 12, 505�-522.

Campbell, J. Y. and Vuolteenaho, T.: 2004a, Bad beta, good beta, American Economic Review 94, 1249�-1275.

Campbell, J. Y. and Vuolteenaho, T.: 2004b, Inflation illusion and stock prices, American Economic Review 94, 19�23. (Proceedings issue).

Chen, L. and Zhao, X.: 2005, Return decomposition, Michigan State and Kent State University, mimeo.

Cogley, T. and Sargent, T. J.: 2006, Drifts and volatilities: Monetary policies and outcomes in the post WWII U.S., Review of Economic Dynamics 8, 262�-302.

Cogley, T. and Sargent, T. J.: 2007, The market price of risk and the equity premium: A legacy of the Great depression?, Journal of Monetary Economics 55(3), 454�-476.

Costa, O., Fragoso, M. and Marques, R.: 2004, Discrete-Time Markov Jump Linear Systems, Springer, New York.

Daniel, K. and Titman, S.: 2006, Testing factor-model explanations of market anomalies, The Kellogg School at Northwestern University and NBER, mimeo.

Farmer, R. E. A.,Waggoner, D. and Zha, T.: 2009, Understanding markov-switching rational expectations models, Journal of Economic Theory 144, 1849-�1867.

Gabaix, X.: 2007, Variable rare disasters: An exactly solved framework for ten puzzles in macro-�nance, NBER and NYU working paper.

Jacquier, E., Polson, N. and Rossi, P.: 2004, Bayesian analysis of stochastic volatility models, Journal of Business and Economic Statistics 12, 371�-418.

Julliard, C. and Ghosh, A.: 2008, Can rare events explain the equity premium puzzle?, London School of Economics and Political Science, mimeo.

Kim, C.-J. and Nelson, C. R.: 1999a, Has the u.s. economy become more stable? a bayesian approach based on a Markov-switching model of the business cycle, The Review of Eco- nomics and Statistics 81(4), 608-�616.

Kim, C.-J. and Nelson, C. R.: 1999b, State-Space Models with Regime Switching, MIT Press, Cambridge, Massachusetts.

Lewellen, J., Nagel, S. and Shanken, J.: 2008, A skeptical appraisal of asset-pricing tests, Journal of Financial Economics . forthcoming.

Merton, R.: 1973, An intertemporal capital asset pricing model, Econometrica 41(4), 867�-887.

Primiceri, G.: 2005, Time varying structural vector autoregressions and monetary policy, The Review of Economic Studies 72(3), 821-�852.

Rietz, T. A.: 1988, The equity risk premium: A solution, Journal of Monetary Economics 22, 117�-131.

Sandroni, A.: 1998, Learning, rare events, and recurrent market crashes in frictionless economies without intrinsic uncertainty, Journal of Economic Theory 82(1), 1�18.

Sims, C. A.: 2003, Implications of rational inattention, Journal of Monetary Economics 50(3), 975�-1000.

Sims, C. A.: 2006, Rational inattention: Beyond the linear-quadratic case, American Economic Review 96(2), 158�-163. (Proceedings issue).

Sims, C. A., Waggoner, D. F. and Zha, T.: 2008, Methods for inference in large multiple-equation Markov-switching models, Journal of Econometrics 146, 113�-144.

Sims, C. A. and Zha, T.: 1998, Bayesian methods for dynamic multivariate models, International Economic Review 39(4), 949-�968.

Sims, C. A. and Zha, T.: 2006,Were there regime switches in US monetary policy?, American Economic Review 91(1), 54-�81.

Thomas, J. and Zhang, F.: 2007, Inflation illusion and stock prices: Comment, Yale University, working paper.

Uhlig, H.: 2005,What are the effects of monetary policy on output? Results from an agnostic identi�cation procedure, Journal of Monetary Economics 52, 381-�419.

Veronesi, P.: 2004, The peso problem hypothesis and stock market returns, Journal of Economic Dynamics and Control 28(4), 707�-725.

Wei, C. and Joutz, F.: 2009, Inflation illusion or no illusion: What did pre- and post-war data say?, George Washington University, working paper.