Karen K. Lewis, University of Pennsylvania and NBER, and Edith Liu, Federal Reserve Board of Governors

Disaster Risk and Asset Returns: An International Perspective

Recent studies have shown that disaster risk can generate an equity premium similar to the data. Moreover, time variation in the risk of disasters can help explain the excess volatility of equity returns over that of government bill rates. However, these studies have ignored the cross-country asset pricing implications of the disaster risk model. This paper shows that standard disaster risk model assumptions lead to counterfactual international asset pricing implications. Given consumption pricing moments, disaster risk cannot explain the range of equity premia and government bill rates nor the high degree of equity return correlation. Moreover, the independence of disasters presumed in some studies generates counterfactually low cross-country correlations in equity markets. Alternatively, if disasters are all shared, the model generates correlations that are excessively high.Lewis and Liu show that common and idiosyncratic components of disaster risk are needed to explain the pattern in consumption and equity co-movements.