Disaster Begets Crisis: The Role of Contagion in Financial Markets

Abstract

Severe economic downturns like the great depression of the 1930s take place over extended periods of time. I model an economy where rare economic disasters increase the likelihood of subsequent near term disasters. The mechanism generates more clustering of disasters than existing models. Serial correlation in disasters has important implications for asset prices. For example, it generates a larger equity premium and a lower risk free rate than similarly calibrated models without this feature. The calibrated model developed here replicates the temporal structure of severe economic downturns in OECD countries. It quantitatively explains the equity premium, the risk-free rate, excess volatility and return predictability. It also generates the implied volatility smile observed in equity index options.