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On the Size Distribution of Macroeconomic Disasters

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  • Robert J. Barro
  • Tao Jin

Abstract

In the rare-disasters setting, a key determinant of the equity premium is the size distribution of macroeconomic disasters, gauged by proportionate declines in per capita consumption or GDP. The long-term national-accounts data for up to 36 countries provide a large sample of disaster events of magnitude 10% or more. For this sample, a power-law density provides a good fit to the distribution of the ratio of normal to disaster consumption or GDP. The key parameter of the size distribution is the upper-tail exponent, α, estimated to be near 5, with a 95% confidence interval between 3-1/2 and 7. The equity premium involves a race between α and the coefficient of relative risk aversion, γ. A higher α signifies a thinner tail and, therefore, a lower equity premium, whereas a higher γ implies a higher equity premium. The equity premium is finite if α 1>γ. To accord with the observed average unlevered equity premium of around 5%, we get a point estimate for γ close to 3, with a 95% confidence interval of roughly 2 to 4.

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Bibliographic Info

Article provided by Econometric Society in its journal Econometrica.

Volume (Year): 79 (2011)
Issue (Month): 5 (09)
Pages: 1567-1589

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Handle: RePEc:ecm:emetrp:v:79:y:2011:i:5:p:1567-1589

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Cited by:
  1. Salvador Pueyo, 2013. "Is it a power law distribution? The case of economic contractions," Papers 1310.2567, arXiv.org.
  2. Max Gillman & Michal Kejak & Michal Pakos, 2014. "Learning about Rare Disasters: Implications for Consumptions and Asset Prices," CEU Working Papers 2014_2, Department of Economics, Central European University.
  3. Jerry Tsai & Jessica A. Wachter, 2014. "Rare Booms and Disasters in a Multi-sector Endowment Economy," NBER Working Papers 20062, National Bureau of Economic Research, Inc.
  4. Kadan, Ohad & Liu, Fang, 2014. "Performance evaluation with high moments and disaster risk," Journal of Financial Economics, Elsevier, vol. 113(1), pages 131-155.
  5. Robert J. Barro & José F. Ursúa, 2012. "Rare Macroeconomic Disasters," Annual Review of Economics, Annual Reviews, vol. 4(1), pages 83-109, 07.
  6. Robert S. Pindyck, 2012. "The Climate Policy Dilemma," NBER Working Papers 18205, National Bureau of Economic Research, Inc.
  7. Dolmas, Jim, 2013. "Disastrous disappointments: asset-pricing with disaster risk and disappointment aversion," Working Papers 1309, Federal Reserve Bank of Dallas.
  8. Joshua Aizenman & Ilan Noy, 2013. "Public and Private Saving and the Long Shadow of Macroeconomic Shocks," NBER Working Papers 19067, National Bureau of Economic Research, Inc.
  9. Larry Epstein & Emmanuel Farhi & Tomasz Stralezcki, . "How Much Would You Pay To Resolve Long-Run Risk?," Working Paper 136671, Harvard University OpenScholar.
  10. Adam, Klaus & Grill, Michael, 2013. "Optimal sovereign default," Discussion Papers 09/2013, Deutsche Bundesbank, Research Centre.
  11. Lars-Alexander Kuehn & Nicolas Petrosky-Nadeau & Lu Zhang, 2012. "An Equilibrium Asset Pricing Model with Labor Market Search," NBER Working Papers 17742, National Bureau of Economic Research, Inc.
  12. Max Gillman & Michal Kejak & Michal Pakos, 2014. "Learning about Disaster Risk: Joint Implications for Consumption and Asset Prices," CERGE-EI Working Papers wp507, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  13. repec:bos:wpaper:wp2013-002 is not listed on IDEAS

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