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Duke Economics Working Paper #03-16

Rational Pessimism, Rational Exuberance, and Markets for Macro Risks


Ravi Banal, A. Ronald Gallant
and
George Tauchen

Abstract

The paper examines two asset pricing models that attempt to explain features of financial markets such as the size of the equity premium and the volatility of the stock market. One model, based on Bansal and Yaron (2002), relies on low frequency movements in aggregate consumption growth, cash-flows, and economic uncertainty as the key channels to interpret asset market behavior. The other, as typified by Campbell and Cochrane (1999), relies on time-varying risk-aversion and consequently time-variation in the risk-premia as the key channel to interpret asset markets. The models are fitted to data using a simulation-based procedure similar to that proposed by Smith (1993). Both models are found to fit the data equally well at conventional significance levels, and they can track quite closely a new measure of realized annual volatility. Their economic implications, however, are different in some important respects. For instance, the models predict quite different characteristics for the price of a perpetual consumption claim in a macro market of the sort proposed by Shiller (1998).

Keywords and Phrases: Asset Pricing, Stochastic Volatility

JEL: E00, G12, C51, C52

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54 pages