Asset Pricing in Production Economies with Learning About Rare Disasters

Abstract

In rare disaster models, it is a major challenge to generate large equity premium and low risk-free rate by imposing realistic consumption jump size. This paper addresses this issue based on a dynamic general equilibrium production economy with learning about rare disasters. Essentially, the information about fundamentals driving rare downward jumps in the output process is not perfect and Bayesian learning is adopted to update beliefs about the likelihood of rare disasters. In the model, the belief dynamics are essential to reconcile the tension between financial markets and consumption data. Additionally, learning about high versus low disaster intensity can generate empirically plausible trend for the investment-output ratio. The economy also features that the impact of parameter uncertainty accounts for a substantial fraction of the total welfare effects of rare disasters.