Disaster Risk and Its Implications for Asset Pricing

Jerry Tsai () and Jessica A. Wachter ()
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Jerry Tsai: Department of Economics and Oxford-Man Institute of Quantitative Economics, University of Oxford, Oxford OX1 3UQ, United Kingdom
Jessica A. Wachter: Department of Finance, The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104

Annual Review of Financial Economics, 2015, vol. 7, issue 1, 219-252

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.

Keywords: equity premium puzzle; fat tails; rare events; volatility puzzle (search for similar items in EconPapers)
JEL-codes: G11 G12 G13 (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (56)

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