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The Time-Varying Risk of Macroeconomic Disasters

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  • Roberto Marfè
  • Julien Penasse

Abstract

While time-varying disasters can explain many characteristics of financial markets, their quantitative assessment is still missing. We propose a latent variable approach to estimate the time-varying probability of a macroeconomic disaster, using a dataset of 42 countries over more than 100 years. We find that disaster risk is volatile and persistent, strongly correlates with the dividend yield, and forecasts stock returns. A state-of-the-art model calibrated with our disaster risk estimates generates a large and volatile equity premium and a low risk free rate under standard assumptions. This evidence supports the idea that investors' fear of disasters drives equity premium dynamics.

Suggested Citation

  • Roberto Marfè & Julien Penasse, 2016. "The Time-Varying Risk of Macroeconomic Disasters," Carlo Alberto Notebooks 463, Collegio Carlo Alberto.
    • Handle: RePEc:cca:wpaper:463
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    More about this item

    Keywords

    rare disasters; equity premium; return predictability; state-space model;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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