"Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance", Quarterly Journal of Economics, 2012, vol. 127(2), p. 645-700.
Ten puzzling features of the macro-finance data are natural outcomes of a model where investors have time-varying perceptions of the risk of economic disaster.
This article incorporates a time-varying severity of disasters into the hypothesis proposed by Rietz (1988) and Barro (2006) 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. Using
the recent technique of linearity-generating processes, the model is tractable and all prices are exactly solved in closed form. In this article’s framework,the following empirical regularities can be understood quantitatively: (i) equity premium puzzle; (ii) risk-free rate puzzle; (iii) excess volatility puzzle; (iv)predictability of aggregate stock market returns with price-dividend ratios; (v)
often greater explanatory power of characteristics than covariances for asset returns; (vi) upward-sloping nominal yield curve; (vii) predictability of future bond excess returns and long-term rates via the slope of the yield curve; (viii) corporate bond spread puzzle; (ix) high price of deep out-of-the-money puts; and (x) high put prices being followed by high stock returns. The calibration passes a variance bound test, as normal-times market volatility is consistent with the
wide dispersion of disaster outcomes in the historical record. The model extends to a setting with many factors and to Epstein-Zin preferences.
JEL Codes: E43,E44, G12.