Disaster Risk and its Implications for Asset Pricing
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.
Forthcoming in the Annual Review of Financial Economics, doi: 10.1146/annurev-financial-111914-041906. We thank Robert Barro, Xavier Gabaix, and Mete Kilic for helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Jerry Tsai & Jessica A. Wachter, 2015. "Disaster Risk and Its Implications for Asset Pricing," Annual Review of Financial Economics, vol 7(1), pages 219-252.