Working Paper: NBER ID: w13724
Authors: Xavier Gabaix
Abstract: This paper incorporates a time-varying intensity of disasters in the Rietz-Barro hypothesis that risk premia result from the possibility of rare, large disasters. During a disaster, an asset's fundamental value falls by a time-varying amount. This in turn generates time-varying risk premia and thus volatile asset prices and return predictability. Using the recent technique of linearity-generating processes (Gabaix 2007), the model is tractable, and all prices are exactly solved in closed form. In the "variable rare disasters" framework, the following empirical regularities can be understood qualitatively: (i) equity premium puzzle (ii) risk-free rate-puzzle (iii) excess volatility puzzle (iv) predictability of aggregate stock market returns with price-dividend ratios (v) value premium (vi) often greater explanatory power of characteristics than covariances for asset returns (vii) upward sloping nominal yield curve (viiii) a steep yield curve predicts high bond excess returns and a fall in long term rates (ix) corporate bond spread puzzle (x) high price of deep out-of-the-money puts. I also provide a calibration in which those puzzles can be understood quantitatively as well. The fear of disaster can be interpreted literally, or can be viewed as a tractable way to model time-varying risk-aversion or investor sentiment.
Keywords: rare disasters; macrofinance; asset pricing; risk premia
JEL Codes: E43; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| disaster occurrence (H84) | drop in asset values (G19) |
| drop in asset values (G19) | time-varying risk premia (C22) |
| perceived riskiness (D81) | stock prices (G12) |
| time-varying intensity of disasters (H84) | predictability of stock returns (G17) |
| higher resilience (D29) | lower ex ante risk premiums for stocks (G12) |