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Rare Disasters and the Equity Premium in a Two-Country World

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Abstract

We extend the Barro (2006) closed-economy model of the equity risk premium in the presence of extreme events ("disasters") to a two-country world. In this more general setting, both the output risk of rare disasters and the associated risk of a default on Government debt, can be diversified. The extent to which agents in one country can diversify away the risk of extreme events depends on the relative size of the two countries, and critically on the probability of a disaster in one country conditional on a disaster in the other. We show that, using Barro's own calibration in combination with a broad range of plausible values for the additional parameters, the model implies levels of the equity risk premium far lower than those typically observed in the data. We conclude that the model is unlikely to explain the equity risk premium

Suggested Citation

  • Copeland, Laurence & Zhu, Yanhui, 2007. "Rare Disasters and the Equity Premium in a Two-Country World," Cardiff Economics Working Papers E2007/6, Cardiff University, Cardiff Business School, Economics Section.
  • Handle: RePEc:cdf:wpaper:2007/6
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    Cited by:

    1. Christian Julliard & Anisha Ghosh, 2012. "Can Rare Events Explain the Equity Premium Puzzle?," Review of Financial Studies, Society for Financial Studies, vol. 25(10), pages 3037-3076.
    2. Vinay Asthana, 2013. "Street-smart asset pricing," Applied Financial Economics, Taylor & Francis Journals, vol. 23(17), pages 1371-1381, September.
    3. Berkman, Henk & Jacobsen, Ben & Lee, John B., 2011. "Time-varying rare disaster risk and stock returns," Journal of Financial Economics, Elsevier, vol. 101(2), pages 313-332, August.

    More about this item

    Keywords

    equity risk premium; default risk; international diversification;

    JEL classification:

    • F3 - International Economics - - International Finance
    • G1 - Financial Economics - - General Financial Markets

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