Asset pricing dynamics in a fragile economy: theory and evidence

Abstract

Economic fragility affects not only the level of asset prices, but also the conditional moments of asset returns. This dissertation models a fragile economy that ìbreaksî when productivity drops below a certain threshold. The anticipated time of this break plays an important role in determining conditional asset prices. The result is that (i) asset prices vary through time even if dividend levels are constant, and (ii) the equity premium and volatility are higher than in an equivalent exchange economy. Calibrating the model shows that asset prices exhibit an equity premium, volatility, and time-series predictability that are all consistent with the empirical observations. I compare the empirical implications of conditional moments of asset returns to other variables that have been used to predict either conditional excess returns or conditional volatility, and find that the theory presented here results in variables with stronger predictive power.