Rare Events and the Equity Premium

Abstract:

The potential for rare economic disasters explains a lot of asset-pricing puzzles. I calibrate disaster probabilities from the twentieth century global history, especially the sharp contractions associated with World War I, the Great Depression, and World War II. The puzzles that can be explained include the high equity premium, low risk-free rate, and volatile stock returns. Another mystery that may be resolved is why expected real interest rates were low in the United States during major wars, such as World War II. The model, an extension of Rietz [1988], maintains the tractable framework of a representative agent, time-additive and iso-elastic preferences, and complete markets. The results hold with i.i.d. shocks to productivity growth in a Lucas-tree type economy and also with the inclusion of capital formation.