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Disaster Risk and its Implications for Asset Pricing

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  • Jerry Tsai
  • Jessica A. Wachter

Abstract

After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing, and the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.

Suggested Citation

  • Jerry Tsai & Jessica A. Wachter, 2015. "Disaster Risk and its Implications for Asset Pricing," NBER Working Papers 20926, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:20926
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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