DP14588 Valuation Risk Revalued

Author(s): Oliver de Groot, Alexander Richter, Nathaniel Throckmorton
Publication Date: April 2020
Keyword(s): Asset Pricing, Equity premium puzzle, recursive utility, Risk-Free Rate Puzzle
JEL(s): C15, D81, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14588

This paper shows the success of valuation risk-time-preference shocks in Epstein-Zin utility-in resolving asset pricing puzzles rests sensitively on the way it is introduced. The specification used in the literature violates several desirable properties of recursive preferences because the weights in the Epstein-Zin time-aggregator do not sum to one. When we revise the specification in a simple asset pricing model the puzzles resurface. However, when estimating a sequence of increasingly rich models, we find valuation risk under the revised specification consistently improves the ability of the models to match asset price and cash-flow dynamics.