Rare Events and the Equity Premium
AbstractThe 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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Date of creation: May 2005
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This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-06-05 (All new papers)
- NEP-BEC-2005-06-05 (Business Economics)
- NEP-DGE-2005-06-05 (Dynamic General Equilibrium)
- NEP-RMG-2005-06-05 (Risk Management)
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Blog mentionsAs found by EconAcademics.org, the blog aggregator for Economics research:
- Tom Sargent on Macro: All's Well
by Eric Falkenstein in Falkenblog on 2010-11-10 02:13:00
- On low probability catastrophic events
by Economic Logician in Economic Logic on 2008-06-11 18:13:00
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