D. Stock Prices in Economy IIWe now calculate stock prices in a more general economy where consump-
tion and dividends are modeled as distinct processes. Table 7.3 presents our
choice of parameters in this economy. To make comparison easier, we also
show the parameters used for Economy I alongside.
Allowing consumption and dividends to follow different processes in-
troduces three new parameters: gD, the mean dividend growth rate; σD,
the volatility of dividend growth; and ω, the correlation of shocks to divi-
dend growth and consumption growth. For simplicity, we set gD=gC=
0.0184. Using NYSE data from 1926–1995 from CRSP, we find σD=
0.12. Campbell (2000) estimates ω in a time series of U.S. data spanning
the past century, and based on his results, we set ω=0.15. As the table
shows, we keep all other parameters fixed at the values discussed in sub-
section 5.A.
Figure 7.5 presents price/dividend ratios that solve equation (34) for
three different values of b 0 : 0.7, 2, and 100, with kfixed at 3. Uncondi-
tional moments of stock returns are shown in table 7.4 for various values
of b 0 and k. The top panel keeps kfixed at 3, bringing the average degree of
loss aversion close to 2.25. A quick comparison with table 7.2 shows that
separating consumption and dividends improves the results significantly.
The volatility of returns is now much higher than what we obtained in
Economy I because dividend growth volatility is now 12 percent rather
than just 3.79 percent. The equity premium is also much higher: the in-
vestor now sees far more severe downturns in the stock market and charges
a much larger premium as compensation.
PROSPECT THEORY AND ASSET PRICES 253Table 7.3
Parameter Values for Economy IIParameter Economy II Economy I
gC 1.84% 1.84%
gD 1.84% —
σC 3.79% 3.79%
σD 12.0% —
ω 0.15 —
γ 1.0 1.0
ρ 0.98 0.98
λ 2.25 2.25
k (range) (range)
b 0 (range) (range)
η 0.9 0.9
The parameter values used for Economy I and shown in table 7.1
are repeated here for ease of comparison.