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Learning, Rare Disasters, and Asset Prices

  • Lu, Yang

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

  • Siemer, Michael


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

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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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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  2. Nengjiu Ju & Jianjun Miao, 2010. "Ambiguity, Learning, and Asset Returns," CEMA Working Papers 438, China Economics and Management Academy, Central University of Finance and Economics.
  3. Xavier Gabaix & Samuel Fraiberg & Romain Ranciere & Adrien Verdehlha & Emmanuel Farhi, 2010. "Crash Risk in Currency Market," 2010 Meeting Papers 640, Society for Economic Dynamics.
  4. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
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  11. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  12. Tim Bollerslev & Viktor Todorov, 2010. "Tails, Fears and Risk Premia," Working Papers 10-33, Duke University, Department of Economics.
  13. Jessica Wachter, 2008. "Can time-varying risk of rare disasters explain aggregate stock market volatility?," 2008 Meeting Papers 944, Society for Economic Dynamics.
  14. Anisha Ghosh & Christian Julliard, 2008. "Can Rare Events Explain the Equity Premium Puzzle?," 2008 Meeting Papers 1090, Society for Economic Dynamics.
  15. 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.
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  18. Backus, David & Chernov, Mikhail & Martin, Ian, 2009. "Disasters implied by equity index options," CEPR Discussion Papers 7416, C.E.P.R. Discussion Papers.
  19. 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.
  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. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
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