Asset Prices, Epstein Zin Utility, and Endogenous Economic Disasters

The financial and economic crisis of 2007-2009 has emphasized the importance of understanding the interplay between asset markets and goods and factor markets. Macroeconomic models, which are consulted to analyze this interplay and to quantitatively assess policy options, have to be consistent with empirical regularities which characterize these markets. Since the publication of Mehra and Prescott (1985), however, many papers have further confirmed the diagnosis that, for a reasonable degree of risk aversion, the historically observed U.S. risk premium (excess of the return on a stock market index over the return of a relatively riskless security) of over 6 percent is an order of magnitude greater than what can be explained within the paradigm of modern macroeconomics, the neoclassical stochastic growth model. This fact has been named ”the equity premium puzzle” in the literature. Over the past years, different attempts have been made in order to solve the puzzle. One approach is concerned with modifying the preference structure from Mehra and Prescott (1985) who assume that the representative household’s lifetime utility is determined as the expected discounted sum of within period CRRA utilities. The standard additive time separable CRRA preference structure implies that the household’s attitude towards uneven consumption paths over time, measured by the elasticity of intertemporal substitution (EIS), and the attitude towards risk from varying consumption levels in different future states, measured by the RRA, are inversely connected. The class of generalized recursive preferences introduced by Epstein and Zin (1989) (EZ) allows for disentanglement of theses quantities. While the equity premium arises since a variety of studies suggest that the coefficient of RRA is a rather small number—Mehra and Prescott (1985) therefore restrict the value to be below 10 in their analysis—there is less evidence against a low EIS close to zero. Hence, even when the RRA is set to a plausible low value, EZ preferences provide an additional, to some degree free parameter in the EIS which can be used to improve the equity premium puzzle. Another promising approach to explain a sizeable equity premium was introduced by Rietz (1988). He modifies the distribution of consumption streams in such way to allow for the possibility of rare but severe economic disasters where consumption is drastically lower. Even when the volatility of consumption (growth) remains in line with the data, the concavity of the utility function guarantees that the risk in the lottery over the marginal utility from consumption increases. Again, a procyclical asset has to offer a higher risk premium. The three essays summarized in this thesis can be understood to be commonly concerned with these two approaches for explaining the historically high equity premium