Working Paper: NBER ID: w20926
Authors: Jerry Tsai; Jessica A. Wachter
Abstract: After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing, and the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.
Keywords: No keywords provided
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| disaster risk (H84) | equity premium (G12) |
| disaster risk (H84) | expected return on risky assets (G17) |
| higher risk of rare disasters (H84) | higher equity returns (G12) |
| disaster risk (H84) | volatility skew in options pricing (G13) |
| absence of observed disasters (H84) | downward bias in observed risk premia (G41) |