Heterogeneous Beliefs about Rare Event Risk in the Lucas Orchard

Piatti, Ilaria (2013) Heterogeneous Beliefs about Rare Event Risk in the Lucas Orchard. Said Business School Working Paper 2014-5.

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This paper investigates the asset pricing implications of investor disagreement about the likelihood of a systemic disaster. I specify a general equilibrium Lucas endowment economy with multiple trees and heterogeneous beliefs about the risk of rare systemic events; the aim is to understand how risk-sharing mechanisms and fear affect equity and variance risk premia, at an aggregate level and in the cross section of stock returns. I first identify a state-dependent conditional link between equity and variance premia, that changes with the cross-sectional distribution of agent consumption. Second, although the risk-neutral stock returns correlation is increasing in the share of pessimistic agents, the correlation computed under the objective measure is not; the result is a countercyclical correlation risk premium. Third, as the number of assets increases, the aggregate variance premium is driven almost entirely by fear of systemic disasters. Empirically, I find that, as anticipated by the model, the variance premium’s power to predict future excess returns is greater during times of financial distress, which typically feature more disagreement among investors. This result holds especially for small stocks, which are more sensitive to systemic rare event risk.

Item Type: Oxford Saïd Research Paper
Keywords: heterogeneous beliefs, systemic disasters, Lucas orchard, variance risk premium, correlation risk premium, predictability, finance
Subject(s): Finance
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Date Deposited: 26 Mar 2015 14:46
Last Modified: 02 Mar 2017 11:38
Funders: not applicable
URI: http://eureka.sbs.ox.ac.uk/id/eprint/5269

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