Rare Events, Financial Crises, And The Cross-Section Of Asset Returns

This paper shows that rare events are important in explaining the cross section of asset returns because of their role in shaping agents' expectations. The author reconsiders the "Bad beta, good beta" ICAPM proposed by Campbell and Vuolteenaho and the author points out that the explanatory power of the model relies on including the stock market crash that opened the Great Depression. When using a Markov-switching VAR, a '30s regime is identified. This regime receives a large weight when forming expectations consistent with the ICAPM, suggesting that the way agents think about financial markets is shaped by what happens during extreme circumstances.