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Rare Events and the Equity Premium

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  • Robert J. Barro

Abstract

The allowance for low-probability disasters, suggested by Rietz (1988), explains a lot of puzzles related to asset returns and consumption. These puzzles include the high equity premium, the low risk-free rate, the volatility of stock returns, and the low values of typical macro-econometric estimates of the intertemporal elasticity of substitution for consumption. Another mystery that may be resolved is why expected real interest rates were low in the United States during major wars, such as World War II. This resolution works even though price-earnings ratios tended also to be low during the wars. This approach achieves these explanations while maintaining the tractable framework of a representative agent, time-additive and iso-elastic preferences, complete markets, and i.i.d. shocks to productivity growth. Perhaps just as puzzling as the high equity premium is why Rietz's framework has not been taken more seriously by researchers in macroeconomics and finance.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11310.

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Date of creation: May 2005
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Handle: RePEc:nbr:nberwo:11310

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  1. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  2. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
  3. Romer, Christina D., 1988. "World War I and the postwar depression A reinterpretation based on alternative estimates of GNP," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 91-115, July.
  4. Bruce Russett & Joel Slemrod, 1992. "Diminished Expectations of Nuclear War and Increased Personal Savings: Evidence From Individual Survey Data," NBER Working Papers 4031, National Bureau of Economic Research, Inc.
  5. Robert E. Hall, 1988. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
  6. John Y. Campbell & Robert J. Shiller, 2001. "Valuation Ratios and the Long-Run Stock Market Outlook: An Update," NBER Working Papers 8221, National Bureau of Economic Research, Inc.
  7. Timothy J. Kehoe & Edward C. Prescott (), 2007. "Great depressions of the twentieth century," Monograph, Federal Reserve Bank of Minneapolis, number 2007gdott.
  8. John Y. Campbell, 2000. "Asset Pricing at the Millennium," Journal of Finance, American Finance Association, vol. 55(4), pages 1515-1567, 08.
  9. Timothy Kehoe & Edward Prescott, 2002. "Data Appendix to Great Depressions of the Twentieth Century," Technical Appendices kehoe02, Review of Economic Dynamics.
  10. Rajnish Mehra & Edward C. Prescott, 2003. "The Equity Premium in Retrospect," NBER Working Papers 9525, National Bureau of Economic Research, Inc.
  11. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  12. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  13. Philippe Jorion & William N. Goetzmann, 1999. "Global Stock Markets in the Twentieth Century," Journal of Finance, American Finance Association, vol. 54(3), pages 953-980, 06.
  14. Casey B. Mulligan, 1997. "Pecuniary Incentives to Work in the U.S. during World War II," NBER Working Papers 6326, National Bureau of Economic Research, Inc.
  15. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  16. Kocherlakota, Narayana R, 1990. " Disentangling the Coefficient of Relative Risk Aversion from the Elasticity of Intertemporal Substitution: An Irrelevance Result," Journal of Finance, American Finance Association, vol. 45(1), pages 175-90, March.
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  1. Tom Sargent on Macro: All's Well
    by Eric Falkenstein in Falkenblog on 2010-11-10 02:13:00
  2. On low probability catastrophic events
    by Economic Logician in Economic Logic on 2008-06-11 18:13:00
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