Institutional Disaster Risk and Asset Pricing: A Unified Framework Integrating Rare Events and Endogenous Political Shocks

Heng-Fu Zou ()

No 777, CEMA Working Papers from China Economics and Management Academy, Central University of Finance and Economics

Abstract: This paper develops a unified institution-based asset pricing model in which rare disasters are reinterpreted as endogenous institutional breakdowns such as revolutions, regime collapses, legal erosion, and constitutional crises - rather than purely exogenous macroeconomic shocks. Building upon and extending the rare disaster literature of Rietz(1988), Barro (2006, 2009), and Gabaix (2012), we model institutional capital as a dynamic stochastic process subject to both continuous fluctuations and discontinuous collapses driven by Poisson jump processes. These institutional shocks directly impact the stochastic discount factor and hence the pricing of risky assets. We analytically derive the resulting equity premium and show that institutional volatility, erosion, and catastrophic regime transitions generate sizable and persistent risk premia even under standard CRRA preferences. Simulations using realistic institutional indi- cators for OECD and emerging economies demonstrate that our model explains not only the magnitude of equity premia, but also their time varia tion and cross-country heterogeneity. The framework unifies consumption based, production-based, and disaster-based asset pricing under the general concept of institutional capital, offering a comprehensive explanation for the equity premium puzzle and broader asset price movements under political uncertainty. We conclude by discussing implications for institutional reform and global financial stability.

Keywords: Institutional capital; equity premium puzzle; rare disasters; stochastic discount factor; political risk; regime shifts; asset pricing; Poisson jumps; macro-finance; constitutional collapse; OECD economies (search for similar items in EconPapers)
Pages: 15 pages
Date: 2025-07-20
New Economics Papers: this item is included in nep-fdg and nep-rmg
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