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Time-series predictability in the disaster model

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  • Gourio, François

Abstract

This paper studies whether the Rietz-Barro "disaster" model, extended for a time-varying probability of disaster, can match the empirical evidence on predictability of stock returns. It is shown that when utility is CRRA, the model cannot replicate this evidence, regardless of parameter values. This motivates extending the disaster model to allow for Epstein-Zin utility. Analytical results show that when the probability of disaster is i.i.d., the model with Epstein-Zin utility can match the evidence on predictability qualitatively if the intertemporal elasticity of substitution is greater than unity. The case of a persistent probability of disaster is studied numerically, with partial success.

Suggested Citation

  • Gourio, François, 2008. "Time-series predictability in the disaster model," Finance Research Letters, Elsevier, vol. 5(4), pages 191-203, December.
    • Handle: RePEc:eee:finlet:v:5:y:2008:i:4:p:191-203
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    More about this item

    Keywords

    Rare events Jumps Disasters Equity premium Return predictability;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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