1932

Abstract

After lying 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 article, 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 as well as 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.

Loading

Article metrics loading...

/content/journals/10.1146/annurev-financial-111914-041906
2015-12-07
2024-06-18
Loading full text...

Full text loading...

/deliver/fulltext/financial/7/1/annurev-financial-111914-041906.html?itemId=/content/journals/10.1146/annurev-financial-111914-041906&mimeType=html&fmt=ahah

Literature Cited

  1. Abel A. 1999. Risk premia and term premia in general equilibrium. J. Monet. Econ. 43:3–33 [Google Scholar]
  2. Backus D, Chernov M, Martin I. 2011. Disasters implied by equity index options. J. Finance 66:1969–2012 [Google Scholar]
  3. Bansal R, Yaron A. 2004. Risks for the long run: a potential resolution of asset pricing puzzles. J. Finance 59:1481–509 [Google Scholar]
  4. Barro RJ. 2006. Rare disasters and asset markets in the twentieth century. Q. J. Econ. 121:823–66 [Google Scholar]
  5. Barro RJ. 2009. Rare disasters, asset prices, and welfare costs. Am. Econ. Rev. 99:243–64 [Google Scholar]
  6. Barro RJ, Ursúa J. 2008. Macroeconomic crises since 1870. Brookings Pap. Econ. Act. 1:255–350 [Google Scholar]
  7. Beeler J, Campbell JY. 2012. The long-run risks model and aggregate asset prices: an empirical assessment. Crit. Finance Rev. 1:141–82 [Google Scholar]
  8. Berkman H, Jacobsen B, Lee JB. 2011. Time-varying rare disaster risk and stock returns. J. Financ. Econ. 101:313–32 [Google Scholar]
  9. Bhamra HS, Strebulaev IA. 2011. The effects of rare economic crises on credit spreads and leverage Work. Pap., Sauder Sch. Bus., Univ. B.C. [Google Scholar]
  10. Boldrin M, Christiano LJ, Fisher JDM. 2001. Habit persistence, asset returns, and the business cycle. Am. Econ. Rev.149–66 [Google Scholar]
  11. Bollerslev T, Todorov V. 2011. Tails, fears, and risk premia. J. Finance 66:2165–211 [Google Scholar]
  12. Boudoukh J, Michaely R, Richardson M, Roberts MR. 2007. On the importance of measuring payout yield: implications for empirical asset pricing. J. Finance 62:877–915 [Google Scholar]
  13. Breeden DT. 1979. An intertemporal asset pricing model with stochastic consumption and investment opportunities. J. Financ. Econ. 7:265–96 [Google Scholar]
  14. Brown SJ, Goetzmann WN, Ross SA. 1995. Survival. J. Finance 50:853–73 [Google Scholar]
  15. Brunnermeier MK, Nagel S, Pedersen LH. 2009. Carry trades and currency crashes. NBER Macroeconomics Annual 2008 D Acemoglu, K Rogoff, M Woodford 313–47 Chicago: Univ. Chicago Press [Google Scholar]
  16. Burnside C, Eichenbaum M, Kleshchelski I, Rebelo S. 2011. Do peso problems explain the returns to the carry trade?. Rev. Financ. Stud. 24:853–91 [Google Scholar]
  17. Calvet LE, Fisher AJ. 2007. Multifrequency news and stock returns. J. Financ. Econ. 86:178–212 [Google Scholar]
  18. Campbell JY. 2003. Consumption-based asset pricing. Handbook of the Economics of Finance 1b G Constantinides, M Harris, R Stulz 803–81 Amsterdam: Elsevier [Google Scholar]
  19. Campbell JY, Cochrane JH. 1999. By force of habit: a consumption-based explanation of aggregate stock market behavior. J. Polit. Econ. 107:205–51 [Google Scholar]
  20. Campbell JY, Shiller RJ. 1988. The dividend–price ratio and expectations of future dividends and discount factors. Rev. Financ. Stud. 1:195–228 [Google Scholar]
  21. Campbell JY, Shiller RJ. 1991. Yield spreads and interest rate movements: a bird's eye view. Rev. Econ. Stud. 58:495–514 [Google Scholar]
  22. Chabi-Yo F, Ruenzi S, Weigert F. 2014. Crash sensitivity and the cross-section of expected stock returns Work. Pap., Fisher Coll. Bus., Ohio State Univ. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2011746 [Google Scholar]
  23. Chen H, Joslin S, Tran N-K. 2012. Rare disasters and risk sharing with heterogeneous beliefs. Rev. Financ. Stud. 25:2189–224 [Google Scholar]
  24. Chernove M, Graveline JJ, Zviadadze I. 2015. Crash risk in currency returns Work. Pap., Univ. Calif., Los Angeles [Google Scholar]
  25. Cochrane JH. 1992. Explaining the variance of price-dividend ratios. Rev. Financ. Stud. 5:243–80 [Google Scholar]
  26. Cochrane JH, Piazzesi M. 2005. Bond risk premia. Am. Econ. Rev. 95:138–60 [Google Scholar]
  27. Collin-Dufresne P, Johannes M, Lochstoer LA. 2013. Parameter learning in general equilibrium: the asset pricing implications NBER Work. Pap. 19705. http://www.nber.org/papers/w19705 [Google Scholar]
  28. Constantinides GM. 2008. Comment on “Macroeconomic crises since 1870.”. Brookings Pap. Econ. Act. 1:341–49 [Google Scholar]
  29. Diamond PA. 1982. Wage determination and efficiency in search equilibrium. Rev. Econ. Stud. 49:217–27 [Google Scholar]
  30. Dieckmann S. 2011. Rare event risk and heterogeneous beliefs: the case of incomplete markets. J. Financ. Quant. Anal. 46:459–88 [Google Scholar]
  31. Du D. 2011. General equilibrium pricing of options with habit formation and event risks. J. Financ. Econ. 99:400–26 [Google Scholar]
  32. Du D. 2013. General equilibrium pricing of currency and currency options. J. Financ. Econ. 110:730–51 [Google Scholar]
  33. Duffee GR. 2013. Bond pricing and the macroeconomy. Handbook of the Economics of Finance 2b GM Constantinides, M Harris, RM Stulz 907–68 Amsterdam: North-Holland, 2nd ed.. [Google Scholar]
  34. Duffie D. 2001. Dynamic Asset Pricing Theory Princeton, NJ: Princeton Univ. Press, 3rd ed.. [Google Scholar]
  35. Duffie D, Epstein LG. 1992. Stochastic differential utility. Econometrica 60:353–94 [Google Scholar]
  36. Epstein L, Zin S. 1989. Substitution, risk aversion and the temporal behavior of consumption and asset returns: a theoretical framework. Econometrica 57:937–69 [Google Scholar]
  37. Fama EF, French KR. 1989. Business conditions and expected returns on stocks and bonds. J. Financ. Econ. 25:23–49 [Google Scholar]
  38. Farhi E, Fraiberger SP, Gabaix X, Ranciere R, Verdelhan A. 2015. Crash risk in currency markets NYU Work. Pap. FIN-09-007, New York. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1397668 [Google Scholar]
  39. Farhi E, Gabaix X. 2015. Rare disasters and exchange rates Work. Pap., Harvard Univ., N.Y. Univ. [Google Scholar]
  40. Gabaix X. 2008. Linearity-generating processes: a modelling tool yielding closed forms for asset prices Work. Pap., Stern Sch. Bus., N.Y. Univ. http://pages.stern.nyu.edu/∼xgabaix/papers/linearity.pdf [Google Scholar]
  41. Gabaix X. 2011. Disasterization: a simple way to fix the asset pricing properties of macroeconomic models. Am. Econ. Rev. 101:406–9 [Google Scholar]
  42. Gabaix X. 2012. An exactly solved framework for ten puzzles in macro-finance. Q. J. Econ. 127:645–700 [Google Scholar]
  43. Gao GP, Song Z. 2013. Rare disaster concerns everywhere Work. Pap., Johnson Grad. Sch. Manag., Cornell Univ. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2606345 [Google Scholar]
  44. Gao GP, Song Z, Yang L. 2014. Perceived crash risk and cross-sectional stock returns Work. Pap., Stern Sch. Bus., N.Y. Univ. [Google Scholar]
  45. Gillman M, Kejak M, Pakoš M. 2015. Learning about rare disasters: implications for consumption and asset prices. Rev. Finance 191053–104 [Google Scholar]
  46. Goetzmann WN, Jorion P. 1999. Re-emerging markets. J. Financ. Quant. Anal. 34:1–32 [Google Scholar]
  47. Gourio F. 2012. Disaster risk and business cycles. Am. Econ. Rev. 102:2734–66 [Google Scholar]
  48. Gourio F. 2013. Credit risk and disaster risk. Am. Econ. J. Macroecon. 5:31–34 [Google Scholar]
  49. Hall RE. 1988. Intertemporal substitution in consumption. J. Polit. Econ. 96:221–73 [Google Scholar]
  50. Hansen LP. 2007. Beliefs, doubts and learning: valuing macroeconomic risk. Am. Econ. Rev. 97:1–30 [Google Scholar]
  51. Harrison M, Kreps D. 1979. Martingales and multiperiod securities markets. J. Econ. Theory 20:381–408 [Google Scholar]
  52. Jermann UJ. 1998. Asset pricing in production economies. J. Monet. Econ. 41:257–75 [Google Scholar]
  53. Julliard C, Ghosh A. 2012. Can rare events explain the equity premium puzzle?. Rev. Financ. Stud. 25:3037–76 [Google Scholar]
  54. Jurek JW. 2014. Crash-neutral currency carry trades. J. Financ. Econ. 113:325–47 [Google Scholar]
  55. Kaltenbrunner G, Lochstoer LA. 2010. Long-run risk through consumption smoothing. Rev. Financ. Stud. 23:3190–224 [Google Scholar]
  56. Keim DB, Stambaugh RF. 1986. Predicting returns in the stock and bond markets. J. Financ. Econ. 17:357–90 [Google Scholar]
  57. Kelly B, Jiang H. 2014. Tail risk and asset prices. Rev. Financ. Stud. 272841–71 [Google Scholar]
  58. Larrain B, Yogo M. 2008. Does firm value move too much to be justified by subsequent changes in cash flow?. J. Financ. Econ. 87:200–26 [Google Scholar]
  59. LeRoy SF, Porter RD. 1981. The present-value relation: tests based on implied variance bounds. Econometrica 49:555–74 [Google Scholar]
  60. Lettau M, Uhlig H. 2000. Can habit formation be reconciled with business cycle facts?. Rev. Econ. Dyn. 3:79–99 [Google Scholar]
  61. Lettau M, Wachter JA. 2011. The term structures of equity and interest rates. J. Financ. Econ. 101:90–113 [Google Scholar]
  62. Lettau M, Wachter JA. 2007. Why is long-horizon equity less risky? A duration-based explanation of the value premium. J. Finance. 62:55–92 [Google Scholar]
  63. Longstaff FA, Piazzesi M. 2004. Corporate earnings and the equity premium. J. Financ. Econ. 74:401–21 [Google Scholar]
  64. Maddison A. 2003. The World Economy: Historical Statistics Paris: OECD [Google Scholar]
  65. Malmendier U, Nagel S. 2011. Depression babies: Do macroeconomic experiences affect risk taking?. Q. J. Econ. 126:373–416 [Google Scholar]
  66. Martin I. 2015. The forward premium puzzle in a two-country world. Work. Pap., Stanford Univ.
  67. Manela A, Moreira A. 2013. News implied volatility and disaster concerns Work. Pap., Olin Bus. Sch., Wash. Univ. St. Louis [Google Scholar]
  68. Martin I. 2013. The Lucas orchard. Econometrica 81:55–111 [Google Scholar]
  69. Mehra R, Prescott E. 1985. The equity premium puzzle. J. Monet. Econ. 15:145–61 [Google Scholar]
  70. Mehra R, Prescott E. 1988. The equity risk premium: a solution?. J. Monet. Econ. 22:133–36 [Google Scholar]
  71. Merton RC. 1976. Option pricing when underlying stock returns are discontinuous. J. Financ. Econ. 3:125–44 [Google Scholar]
  72. Mortensen DT, Pissarides CA. 1994. Job creation and job destruction in the theory of unemployment. Rev. Econ. Stud. 61:397–415 [Google Scholar]
  73. Nakamura E, Steinsson J, Barro R, Ursúa J. 2013. Crises and recoveries in an empirical model of consumption disasters. Am. Econ. J. Macroecon. 5:335–74 [Google Scholar]
  74. Nowotny M. 2011. Disaster begets crisis: the role of contagion in financial markets. Work. Pap., Dep. Finance, Boston Univ. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1714754 [Google Scholar]
  75. Petrosky-Nadeau N, Zhang L, Kuehn L-A. 2013. Endogenous economic disasters and asset prices Work. Pap., Fisher Coll. Bus., Ohio State Univ. http://fisher.osu.edu/∼zhang.1868/SearchAP_2013Oct.pdf [Google Scholar]
  76. Piatti I. 2015. Heterogeneous beliefs about rare event risk in the Lucas orchard Work. Pap., Univ. Oxford [Google Scholar]
  77. Rietz TA. 1988. The equity risk premium: a solution. J. Monet. Econ. 22:117–31 [Google Scholar]
  78. Seo SB. 2014. Correlated defaults and economic catastrophes: linking the CDS market and asset returns Work. Pap., Wharton Sch., Univ. Pa. [Google Scholar]
  79. Seo SB, Wachter JA. 2013. Option prices in a model with stochastic disaster risk NBER Work. Pap. 19611. http://www.nber.org/papers/w19611 [Google Scholar]
  80. Shiller RJ. 1981. Do stock prices move too much to be justified by subsequent changes in dividends?. Am. Econ. Rev. 71:421–36 [Google Scholar]
  81. Stambaugh RF. 1988. The information in forward rates: implications for models of the term structure. J. Financ. Econ. 21:41–70 [Google Scholar]
  82. Tsai J. 2014. Rare disasters and the term structure of interest rates Work. Pap., Dep. Econ., Univ. Oxf. http://www.economics.ox.ac.uk/materials/papers/12778/paper665.pdf [Google Scholar]
  83. Tsai J, Wachter JA. 2014a. Pricing long-lived securities in dynamic economies Work. Pap., Dep. Econ., Univ. Oxf. [Google Scholar]
  84. Tsai J, Wachter JA. 2014b. Rare booms and disasters in a multi-sector endowment economy NBER Work. Pap. 20062. http://www.nber.org/papers/w20062 [Google Scholar]
  85. Veronesi P. 2004. The Peso problem hypothesis and stock market returns. J. Econ. Dyn. Control 28:707–25 [Google Scholar]
  86. Wachter JA. 2013. Can time-varying risk of rare disasters explain aggregate stock market volatility?. J. Finance 68:987–1035 [Google Scholar]
  87. Weil P. 1989. The equity premium puzzle and the risk-free rate puzzle. J. Monet. Econ. 24:402–21 [Google Scholar]
  88. Weil P. 1990. Nonexpected utility in macroeconomics. Q. J. Econ. 105:29–42 [Google Scholar]
  89. Weitzman ML. 2007. Subjective expectations and asset-return puzzles. Am. Econ. Rev. 97:1102–30 [Google Scholar]
/content/journals/10.1146/annurev-financial-111914-041906
Loading
/content/journals/10.1146/annurev-financial-111914-041906
Loading

Data & Media loading...

Supplementary Data

  • Article Type: Review Article
This is a required field
Please enter a valid email address
Approval was a Success
Invalid data
An Error Occurred
Approval was partially successful, following selected items could not be processed due to error