%0 Journal Article %1 Gabaix:QJE:2012 %A Gabaix, Xavier %D 2012 %J The Quarterly Journal of Economics %K disaster equity-premium puzzle %N 2 %P 645-700 %R 10.1093/qje/qjs001 %T Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance %U http://qje.oxfordjournals.org/content/127/2/645.abstract %V 127 %X This article incorporates a time-varying severity of disasters into the hypothesis proposed by Rietz (1988) and Barro (2006) that risk premia result from the possibility of rare large disasters. During a disaster an asset's fundamental value falls by a time-varying amount. This in turn generates time-varying risk premia and, thus, volatile asset prices and return predictability. Using the recent technique of linearity-generating processes, the model is tractable and all prices are exactly solved in closed form. In this article's framework, the following empirical regularities can be understood quantitatively: (i) equity premium puzzle; (ii) risk-free rate puzzle; (iii) excess volatility puzzle; (iv) predictability of aggregate stock market returns with price-dividend ratios; (v) often greater explanatory power of characteristics than covariances for asset returns; (vi) upward-sloping nominal yield curve; (vii) predictability of future bond excess returns and long-term rates via the slope of the yield curve; (viii) corporate bond spread puzzle; (ix) high price of deep out-of-the-money puts; and (x) high put prices being followed by high stock returns. The calibration passes a variance bound test, as normal-times market volatility is consistent with the wide dispersion of disaster outcomes in the historical record. The model extends to a setting with many factors and to Epstein-Zin preferences.

@article{Gabaix:QJE:2012, abstract = {This article incorporates a time-varying severity of disasters into the hypothesis proposed by Rietz (1988) and Barro (2006) that risk premia result from the possibility of rare large disasters. During a disaster an asset's fundamental value falls by a time-varying amount. This in turn generates time-varying risk premia and, thus, volatile asset prices and return predictability. Using the recent technique of linearity-generating processes, the model is tractable and all prices are exactly solved in closed form. In this article's framework, the following empirical regularities can be understood quantitatively: (i) equity premium puzzle; (ii) risk-free rate puzzle; (iii) excess volatility puzzle; (iv) predictability of aggregate stock market returns with price-dividend ratios; (v) often greater explanatory power of characteristics than covariances for asset returns; (vi) upward-sloping nominal yield curve; (vii) predictability of future bond excess returns and long-term rates via the slope of the yield curve; (viii) corporate bond spread puzzle; (ix) high price of deep out-of-the-money puts; and (x) high put prices being followed by high stock returns. The calibration passes a variance bound test, as normal-times market volatility is consistent with the wide dispersion of disaster outcomes in the historical record. The model extends to a setting with many factors and to Epstein-Zin preferences.}, added-at = {2014-10-12T01:26:46.000+0200}, author = {Gabaix, Xavier}, biburl = {https://www.bibsonomy.org/bibtex/281428cbe548a5b114b93d45c24df0e7a/fcqms}, description = {Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance}, doi = {10.1093/qje/qjs001}, eprint = {http://qje.oxfordjournals.org/content/127/2/645.full.pdf+html}, interhash = {fcce77b7bbb59c2ffe0b228e3858d050}, intrahash = {81428cbe548a5b114b93d45c24df0e7a}, journal = {The Quarterly Journal of Economics}, keywords = {disaster equity-premium puzzle}, number = 2, pages = {645-700}, timestamp = {2014-10-13T22:53:31.000+0200}, title = {Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance}, url = {http://qje.oxfordjournals.org/content/127/2/645.abstract}, volume = 127, year = 2012 }