Disaster recovery and the term structure of dividend strips

Abstract

Recent empirical findings document downward-sloping term structures of equity return volatility and risk premia. An equilibrium model with rare disasters followed by recoveries helps reconcile theory with empirical observations. Indeed, recoveries outweigh the upward-sloping effect of time-varying disaster intensity and expected growth, generating downward-sloping term structures of dividend growth risk, equity return volatility, and equity risk premia. In addition, the term structure of interest rates is upward-sloping when accounting for recoveries and downward-sloping otherwise. The model quantitatively reconciles high risk premia and a low risk-free rate with the shape of the term structures, which are at odds in other models.