Tuesday, November 12, 2013

The price of long-run risk

In dynamic stochastic models, standard utility function specifications imply that the curvature of this function determines directly both the risk aversion and the elasticity of intertemporal substitution. When calibrating this, modelers have a tendency to be waving hands a bit too much, as they focus more on one than the other. In addition, their calibration seems to be immune to changes in data frequency. Those who are careful about this use Epstein-Zin preferences which disentangle risk aversion and the elasticity of intertemporal substitution. They think they have done all they could to address a proper calibration.

Well, not quite. Larry Epstein, Emmanuel Farhi and Tomasz Strzalecki show there is a third dimension in play, the temporal resolution of long-run risk. Indeed, the interaction of risk aversion and elasticity determines whether economic agents prefer early or late resolution of risk. This matters. Indeed, long-run risk is priced by markets differently than short-term risk, typically higher. Indeed, people are willing to pay to know uncertain outcomes earlier. But we do not know how much so far. An opportunity for additional research.


a jjwinterpretation said...

Very grateful that you put my paper on Fundamental Equation of Economy (FEOE) up for discussion.

From your comment, you are probably not convinced that FEOE exists or will be useful. I just want to assure you that this FEOE is a real deal! (YES. IT IS REAL!) You are not wasting your valuable time on reading and researching on this paper at all.

The paper already proves that FEOE exists, whether you like it or not. I will challenge you to find ONE EXAMPLE where FEOE don't work or not true.

The only remaining question is whether such FEOE is actually useful for future economists. We can work on that. My paper asserts that FEOE can do better than or the same as all existing forecasting models in any area of economics. And if FEOE can do the same as the existing models, then the existing models must be equivalent to FEOE.

These are VERY STRONG statements. Therefore, it is easy to see whether FEOE is useless or not true.

The paper already uses US housing market as an example. The paper shows that FEOE certainly works much better than laws of supply and demand and market equilibrium framework.

Please choose one area in economic forecasting which you and me are an expert. Let's see whether FEOE can tell you anything new. I am an "expert" on personal finance (Do you want to become a millionaire or a billionaire? FEOE helps!), US housing markets, US and Chinese macroeconomics, and US financial markets in general.

Anonymous said...

The comment above pertains to another post.