Asset Pricing in a Production Economy with Chew-Dekel Preferences

Abstract

In this paper we provide a thorough characterization of the asset returns implied by a simple general equilibrium production economy with convex investment adjustment costs. When households have Epstein–Zin preferences, there exist plausible parameter values such that the model generates unconditional mean risk–free rate and equity return, and volatility of consumption growth, which are in line with historical averages for the US economy. Consistently with the data, the price–dividend ratio is pro–cyclical and stock returns are predictable (and increasingly so as the time horizon increases), while dividend growth is not. The model also implies realistic values for (i) the correlation of the risk–free rate with output growth and consumption growth and (ii) the correlation pattern between risk–free rate, equity return, and equity premium. The risk implied by the model is rather low. Given the work of Rabin (2000) among others, it is not surprising that our Epstein–Zin agent exhibits a much higher risk aversion when faced with substantially larger risks. This shortcoming, however, does not extend to the case in which agents are disappointment averse in the sense of Gul (1991). When faced with a lottery that has a coefficient of variation 100 times as large as that implied by our model, a disappointment averse agent displays the same relative risk aversion as an expected utility agent with logarithmic utility!