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Summary Empirical Finance Part II
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Summary Empirical Finance Part II given at Tilburg University in the first half of the master.
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Tilburg UniversityMaster Program
Summary Empirical Finance
Part II
Supervisor:
Author:
de Bresser, J
Rick Smeets
Melenberg, M
October 19, 2024
,Table of Contents
1 Consumption Models 4
1.1 Introduction and Recap . . . . . . . . . . . . . . . . . . . . . 4
1.1.1 Risk Premiums . . . . . . . . . . . . . . . . . . . . . . 4
1.1.2 Classical Model with Power Utility . . . . . . . . . . . 5
1.1.3 Arrow-Pratt Measures of Risk Aversion . . . . . . . . . 6
1.1.4 Consumption-Based Models . . . . . . . . . . . . . . . 6
1.2 Stochastic Discount Factos Nonlinear in Parameters . . . . . . 6
1.2.1 GMM Framework . . . . . . . . . . . . . . . . . . . . . 7
1.2.2 Consistency and Asymptotic Normality . . . . . . . . . 8
2 The Equity Premium Puzzle 9
2.1 An Experiment . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2 The Hansen-Jagannathan Bound . . . . . . . . . . . . . . . . 10
2.3 Formalizing the Equity Premium Puzzle . . . . . . . . . . . . 10
2.3.1 Theoretical vs. Practical Results . . . . . . . . . . . . 12
2.4 Elasticity of Intertemporal Substitution (EIS) . . . . . . . . . 13
3 Habit Formation 14
3.1 The Dynamic Model . . . . . . . . . . . . . . . . . . . . . . . 16
3.2 The Risk Free Return . . . . . . . . . . . . . . . . . . . . . . . 16
3.3 Solution Campbell & Cochrane (1999) . . . . . . . . . . . . . 17
3.3.1 Follow Up Empirical Research . . . . . . . . . . . . . . 17
3.4 Model Comparisons . . . . . . . . . . . . . . . . . . . . . . . . 18
4 Ambiguity 18
4.1 Ambiguity Aversion . . . . . . . . . . . . . . . . . . . . . . . . 19
4.1.1 Ellsberg’s Paradox . . . . . . . . . . . . . . . . . . . . 19
4.1.2 Modeling Ambiguity Aversion . . . . . . . . . . . . . . 20
5 Epstein-Zin Preferences: Background & Empirical Results 21
5.1 Typical Choices . . . . . . . . . . . . . . . . . . . . . . . . . . 22
5.1.1 Stochastic Discount Factor . . . . . . . . . . . . . . . . 24
5.1.2 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
6 Recursive Utility and Long Run Risk 26
6.1 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
6.1.1 Mechanisms . . . . . . . . . . . . . . . . . . . . . . . . 27
1
, 6.1.2 An Approximation . . . . . . . . . . . . . . . . . . . . 28
6.2 The Solution . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
6.2.1 Estimated Model Results . . . . . . . . . . . . . . . . . 31
6.3 EZ Preferences and Ambiguity . . . . . . . . . . . . . . . . . . 32
7 Rare Events & Introduction Behavioral Finance 32
7.1 Rare Disasters . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
7.2 Behavioral Finance . . . . . . . . . . . . . . . . . . . . . . . . 33
7.2.1 Arbitrage Critique . . . . . . . . . . . . . . . . . . . . 33
7.3 Belief Extrapolation . . . . . . . . . . . . . . . . . . . . . . . 34
7.4 Asset Pricing with Return Extrapolation . . . . . . . . . . . . 34
8 Sentiment and Prospect Theory 35
8.1 Strong and Weak Rational Expectations . . . . . . . . . . . . 35
8.2 Sentiment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
8.2.1 SDF-Estimation in a Cross Section . . . . . . . . . . . 39
8.3 Prospect Theory . . . . . . . . . . . . . . . . . . . . . . . . . 40
9 Alternative Consumption Data 43
9.1 Garbage Data . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
9.2 Rare Disasters . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
10 Noise Traders 45
10.1 Siamese Twin Stocks . . . . . . . . . . . . . . . . . . . . . . . 47
11 Applications of Prospect Theory and the DSSW-model 48
11.1 The DSSW-Model . . . . . . . . . . . . . . . . . . . . . . . . . 51
11.1.1 Criticism on the DSSW-model . . . . . . . . . . . . . . 54
12 Bubbles 54
12.1 Traditional Finance: Rational Bubbles . . . . . . . . . . . . . 55
12.1.1 First Characteristics . . . . . . . . . . . . . . . . . . . 56
12.1.2 Bursting Bubbles . . . . . . . . . . . . . . . . . . . . . 57
12.2 Behavioral Finance: Empirical Approach . . . . . . . . . . . . 57
12.3 Econometric Approach . . . . . . . . . . . . . . . . . . . . . . 58
12.4 Testing for Bubbles . . . . . . . . . . . . . . . . . . . . . . . . 58
12.4.1 Some Tests . . . . . . . . . . . . . . . . . . . . . . . . 59
2
, Abstract
Welcome to this summary of Empirical Finance, part II of the series provided
by B. Melenberg (for years later than 2024/2025; it covers most material
provided by Anne Balter as well). This summary is designed to help you
navigate through the essential concepts of the given course. I have compiled
the summary for this course alongside a range of other courses for the master’s
and bachelors program which can be found on Stuvia, including:
• Statistics for Econometrics (Bachelor level)
• Asset Liability Management
• Data Science Methods
• Time Series and its Applications
• Empirical Finance
• Valuation and Risk Management
• Risk and Regulation
While the key information is covered in this summary, it is always helpful to
use it alongside the lecture notes for a deeper understanding. Often, these
summaries explain things in a slightly different way, which can help clarify
complex topics.
Let’s support each other in making our studies a bit easier ;).
You can find my account on Stuvia as: ricksmeets611
3
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