Rational pessimism, rational exuberance, and asset pricing models

Journal Article

The paper estimates and examines the empirical plausibility of 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. In one model, the long-run risks (LRR) model of Bansal and Yaron, low-frequency movements, and time-varying uncertainty in aggregate consumption growth are the key channels for understanding asset prices. In another, as typified by Campbell and Cochrane, habit formation, which generates time-varying risk aversion and consequently time variation in risk premia, is the key channel. These models are fitted to data using simulation estimators. 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. Further, scrutiny using a rich array of diagnostics suggests that the LRR model is preferred. © 2007 The Review of Economic Studies Limited.

Full Text

Duke Authors

Cited Authors

  • Bansal, R; Gallant, AR; Tauchen, G

Published Date

  • 2007

Published In

Volume / Issue

  • 74 / 4

Start / End Page

  • 1005 - 1033

International Standard Serial Number (ISSN)

  • 0034-6527

Digital Object Identifier (DOI)

  • 10.1111/j.1467-937X.2007.00454.x