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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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Find related papers by JEL classification:

• E20 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
• E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
• G01 - Financial Economics - - General - - - Financial Crises
• G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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Cited by:

1. Kuehn, Lars-Alexander & Petrosky-Nadeau, Nicolas & Zhang, Lu, 2011. "An Equilibrium Asset Pricing Model with Labor Market Search," Working Paper Series 2012-01, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
   
   • Kuehn Lars-Alexander & Petrosky-Nadeau Nicolas & Zhang Lu, . "An Equilibrium Asset Pricing Model with Labor Market Search," GSIA Working Papers 2010-E63, Carnegie Mellon University, Tepper School of Business.
   • 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.
2. Robert J. Barro & José F. Ursua, 2011. "Rare Macroeconomic Disasters," NBER Working Papers 17328, National Bureau of Economic Research, Inc.
   
   • Robert J. Barro & José F. Ursúa, 2012. "Rare Macroeconomic Disasters," Annual Review of Economics, Annual Reviews, vol. 4(1), pages 83-109, 07.
3. Adam, Klaus & Grill, Michael, 2012. "Optimal Sovereign Default," CEPR Discussion Papers 9178, C.E.P.R. Discussion Papers.
   
   • Adam, Klaus & Grill, Michael, 2012. "Optimal Sovereign Default," Working Papers 12-16, University of Mannheim, Department of Economics.

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