Variable Rare Disasters: An Exactly Solved Framework For Ten Puzzles In Macro-Finance
Source: New York University
This paper incorporates a time-varying intensity of disasters in the Rietz-Barro hypothesis 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. The author also provides a calibration in which those puzzles can be understood quantitatively as well. The fear of disaster can be interpreted literally, or can be viewed as a tractable way to model time-varying risk-aversion or investor sentiment.