Description:
Embedding disasters into a general equilibrium production economy with heterogeneous firms induces strong nonlinearity in the pricing kernel, helping explain the empirical failure of the (consumption) CAPM. Our single-factor model reproduces the failure of the CAPM in explaining the value premium in finite samples without disasters, and its relative success in samples with disasters. The standard consumption CAPM fails in simulations, even though a nonlinear model with the true pricing kernel holds exactly by construction. Due to beta measurement errors, the relation between the pre-ranking beta and the average return is flat in simulations, consistent with the beta “anomaly,” even though the true beta-expected return relation is strongly positive. In all, the empirical failures of standard asset pricing models should be interpreted with caution