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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.

Suggested Citation

  • Robert J. Barro, 2005. "Rare Events and the Equity Premium," NBER Working Papers 11310, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:11310
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    File URL: http://www.nber.org/papers/w11310.pdf
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    References listed on IDEAS

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    1. 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.
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    8. 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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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Tom Sargent on Macro: All's Well
      by Eric Falkenstein in Falkenblog on 2010-11-10 08:13:00
    2. On low probability catastrophic events
      by Economic Logician in Economic Logic on 2008-06-11 23:13:00

    Citations

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    Cited by:

    1. Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.
    2. Roger E.A. Farmer, 2016. "Pricing Assets in an Economy with Two Types of People," NBER Working Papers 22228, National Bureau of Economic Research, Inc.
    3. Ricardo Caballero & Arvind Krishnamurthy, 2005. "Financial System Risk and Flight to Quality," NBER Working Papers 11834, National Bureau of Economic Research, Inc.
    4. Hashem Pesaran & Davide Pettenuzzo & Allan Timmermann, 2007. "Learning, Structural Instability, and Present Value Calculations," Econometric Reviews, Taylor & Francis Journals, vol. 26(2-4), pages 253-288.
    5. van Ewijk, Casper & de Groot, Henri L.F. & Santing, A.J. (Coos), 2012. "A meta-analysis of the equity premium," Journal of Empirical Finance, Elsevier, vol. 19(5), pages 819-830.
    6. Alejandrina Salcedo & Todd Schoellman & Michèle Tertilt, 2012. "Families as roommates: Changes in U.S. household size from 1850 to 2000," Quantitative Economics, Econometric Society, vol. 3(1), pages 133-175, March.
    7. Blake, David & Cairns, Andrew & Dowd, Kevin, 2008. "Turning pension plans into pension planes: What investment strategy designers of defined contribution pension plans can learn from commercial aircraft designers," MPRA Paper 33749, University Library of Munich, Germany.
    8. Paolo Mauro & Torbjorn I. Becker, 2006. "Output Drops and the Shocks That Matter," IMF Working Papers 06/172, International Monetary Fund.
    9. Luca Benzoni & Pierre Collin-Dufresne & Robert S. Goldstein, 2005. "Can Standard Preferences Explain the Prices of out of the Money S&P 500 Put Options," NBER Working Papers 11861, National Bureau of Economic Research, Inc.
    10. Robert J. Barro, 2009. "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, American Economic Association, vol. 99(1), pages 243-264, March.
    11. George M. Constantinides, 2006. "Market Organization And The Prices Of Financial Assets," Manchester School, University of Manchester, vol. 74(s1), pages 1-23, September.
    12. repec:oup:revfin:v:21:y:2017:i:4:p:1403-1444. is not listed on IDEAS
    13. Rieger, Marc Oliver & Wang, Mei, 2012. "Can ambiguity aversion solve the equity premium puzzle? Survey evidence from international data," Finance Research Letters, Elsevier, vol. 9(2), pages 63-72.
    14. Ricardo J. Caballero & Arvind Krishnamurthy, 2006. "Flight to Quality and Collective Risk Management," NBER Working Papers 12136, National Bureau of Economic Research, Inc.
    15. Jorge A Chan-Lau, 2006. "Is Systematic Default Risk Priced in Equity Returns? A Cross-Sectional Analysis Using Credit Derivatives Prices," IMF Working Papers 06/148, International Monetary Fund.
    16. Milos Bozovic, 2015. "Equity Premium in Serbia: A Different Kind of Puzzle?," MIC 2015: Managing Sustainable Growth; Proceedings of the Joint International Conference, Portorož, Slovenia, 28–30 May 2015, University of Primorska, Faculty of Management Koper.
    17. Gregorio Impavido & Esperanza Lasagabaster & Manuel Garcia-Huitron, 2010. "New Policies for Mandatory Defined Contribution Pensions : Industrial Organization Models and Investment Products," World Bank Publications, The World Bank, number 2462, August.
    18. repec:red:issued:17-287 is not listed on IDEAS
    19. Roger E. A. Farmer, 2018. "Pricing Assets in a Perpetual Youth Model," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 30, pages 106-124, October.
    20. Pawe³ Kliber, 2016. "A puzzle of excessive equity risk premium and the case of Poland," "e-Finanse", University of Information Technology and Management, Institute of Financial Research and Analysis, vol. 12(1), pages 1-11, June.
    21. Tryggvi Gudmundsson, 2016. "Whose Credit Line is it Anyway; An Update on Banks' Implicit Subsidies," IMF Working Papers 16/224, International Monetary Fund.
    22. Kazufumi Yamana, "undated". "Structural Household Finance," Discussion papers ron279, Policy Research Institute, Ministry of Finance Japan.
    23. Salyer, Kevin D., 2007. "Macroeconomic priorities and crash states," Economics Letters, Elsevier, vol. 94(1), pages 64-70, January.
    24. Lehmann, Bruce N., 2009. "The role of beliefs in inference for rational expectations models," Journal of Econometrics, Elsevier, vol. 150(2), pages 322-331, June.

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