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Learning, Rare Disasters, and Asset Prices

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Author Info

  • Lu, Yang

    (Board of Governors of the Federal Reserve System (U.S.))

  • Siemer, Michael

    ()
    (Board of Governors of the Federal Reserve System (U.S.))

Abstract

In this paper, we examine how learning about disaster risk affects asset pricing in an endowment economy. We extend the literature on rare disasters by allowing for two sources of uncertainty: (1) the lack of historical data results in unknown parameters for the disaster process, and (2) the disaster takes time to unfold and is not directly observable. The model generates time variation in the risk premium through Bayesian updating of agents' beliefs regarding the likelihood and severity of disaster realization. The model accounts for the level and volatility of U.S. equity returns and generates predictability in returns.

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File URL: http://www.federalreserve.gov/pubs/feds/2013/201385/201385pap.pdf
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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2013-85.

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Length: 33 pages
Date of creation: 01 Nov 2013
Date of revision:
Handle: RePEc:fip:fedgfe:2013-85

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Related research

Keywords: Rare disasters; Bayesian learning; equity premium puzzle; time-varying risk premia; return predictability;

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References

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  1. Jun Liu, 2005. "An Equilibrium Model of Rare-Event Premia and Its Implication for Option Smirks," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 131-164.
  2. Jianjun Miao & NENGJIU JU, 2010. "Ambiguity, Learning, And Asset Returns," Boston University - Department of Economics - Working Papers Series WP2010-031, Boston University - Department of Economics.
  3. David Backus & Mikhail Chernov & Ian Martin, 2009. "Disasters implied by equity index options," NBER Working Papers 15240, National Bureau of Economic Research, Inc.
  4. Martin L. Weitzman, 2007. "Subjective Expectations and Asset-Return Puzzles," American Economic Review, American Economic Association, vol. 97(4), pages 1102-1130, September.
  5. Allan Timmermann, 1998. "Structural Breaks, Incomplete Information and Stock Prices," FMG Discussion Papers dp311, Financial Markets Group.
  6. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
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  8. Robert J. Barro & José F. Ursúa, 2009. "Stock-Market Crashes and Depressions," NBER Working Papers 14760, National Bureau of Economic Research, Inc.
  9. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08.
  10. Xavier Gabaix & Samuel Fraiberg & Romain Ranciere & Adrien Verdehlha & Emmanuel Farhi, 2010. "Crash Risk in Currency Market," 2010 Meeting Papers 640, Society for Economic Dynamics.
  11. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  12. Abel, Andrew B., 1999. "Risk premia and term premia in general equilibrium," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 3-33, February.
  13. Anisha Ghosh & Christian Julliard, 2008. "Can Rare Events Explain the Equity Premium Puzzle?," 2008 Meeting Papers 1090, Society for Economic Dynamics.
  14. Emmanuel Farhi & Xavier Gabaix, 2008. "Rare Disasters and Exchange Rates," NBER Working Papers 13805, National Bureau of Economic Research, Inc.
  15. hui chen & michal pakos, . "Rational Overreaction and Underreaction in Fixed Income and Equity Markets - The Role of Time-Varying Timing Premium," GSIA Working Papers 2007-E24, Carnegie Mellon University, Tepper School of Business.
  16. Jessica Wachter, 2008. "Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?," NBER Working Papers 14386, National Bureau of Economic Research, Inc.
  17. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  18. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  19. Xavier Gabaix, 2008. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," NBER Working Papers 13724, National Bureau of Economic Research, Inc.
  20. Anisha Ghosh & George M. Constantinides, 2010. "The Predictability of Returns with Regime Shifts in Consumption and Dividend Growth," NBER Working Papers 16183, National Bureau of Economic Research, Inc.
  21. David S. Bates, 2009. "U.S. Stock Market Crash Risk, 1926-2006," NBER Working Papers 14913, National Bureau of Economic Research, Inc.
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Cited by:
  1. 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.

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