Valuation Risk and Asset Pricing

Abstract

Standard representative-agent models have di¢culty in accounting for the weak correlation between stock returns and measurable fundamentals, such as consumption and output growth. This failing underlies virtually all modern asset-pricing puzzles. The correlation puzzle arises because these models load all uncertainty onto the supply side of the economy. We propose a simple theory of asset pricing in which demand shocks play a central role. These shocks give rise to valuation risk that allows the model to account for key asset pricing moments, such as the equity premium, the bond term premium, and the weak correlation between stock returns and fundamentals.J.E.L. Classification: G12.

Asset Prices and Unemployment Fluctuations

“…We consider next a model with Epstein-Zin preferences, a slow-moving predictable component in productivity as in Bansal and Yaron (2004), and discount rate shocks as in Albuquerque et al (2016) and Schorfheide et al (2018). In particular, preferences are now given by…”

“…We then examine two versions of the preferences in Epstein and Zin (1989). We first consider a version of the long-run risk setup of Bansal and Yaron (2004) with preferences as in Epstein and Zin (1989), modified along the lines suggested by Albuquerque, Eichenbaum, Luo, and Rebelo (2016) and Schorfheide, Song, and Yaron (2018). Albuquerque et al (2016) show that a model that combines long-run risk with preference shocks replicates well observed features of asset prices.…”

Rethinking Production Under Uncertainty

“…This trouble ought to be particularly salient for behavioral finance and intermediary asset pricing, which explicitly posits that preference shocks are a central driving mechanism. As a concrete example, see Albuquerque et al (2016) for preference shocks in a detailed macro-finance model, and Kruger (2019) for critique that it misses important moments.…”

Informality and bank stability

“…In standard asset pricing models, uncertainty enters through the supply side of the economy, either through endowment shocks in a Lucas (1978) tree model or productivity shocks in a production economy model. Recently, several papers introduced demand side uncertainty or "valuation risk" as a potential explanation of key asset pricing puzzles (Albuquerque et al, 2016(Albuquerque et al, , 2015Creal and Wu, 2017;Maurer, 2012;Nakata and Tanaka, 2016;Schorfheide et al, 2018). In macroeconomic parlance, valuation risk is typically referred to as a discount factor or time preference shock.…”

“…It is common in the asset pricing literature to estimate models using a simulated method of moments procedure (eg., Adam et al, 2016;Albuquerque et al, 2016;Andreasen and Jørgensen, 2019). We build on the existing methodology in two ways.…”