Peso problems in the estimation of the C-CAPM

Juan Carlos Parra-Alvarez, Olaf Posch*, Andreas Schrimpf

*Corresponding author for this work

Research output: Contribution to journal/Conference contribution in journal/Contribution to newspaperJournal articleResearchpeer-review

1 Citation (Scopus)

Abstract

This paper shows that the consumption-based capital asset pricing model (C-CAPM) with low-probability disaster risk rationalizes pricing errors. We find that implausible estimates of risk aversion and time preference are not puzzling if market participants expect a future catastrophic change in fundamentals, which just happens not to occur in the sample (a “peso problem”). A bias in structural parameter estimates emerges as a result of pricing errors in quiet times. While the bias essentially removes the pricing error in the simple models when risk-free rates are constant, time-variation may also generate large and persistent estimated pricing errors in simulated data. We also show analytically how the problem of biased estimates can be avoided in empirical research by resolving the misspecification in moment conditions.

Original languageEnglish
JournalQuantitative Economics
Volume13
Issue1
Pages (from-to)259-313
Number of pages55
ISSN1759-7323
DOIs
Publication statusPublished - Jan 2022

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