Abstract
Using a rare disaster risk database from almost the last one hundred years, we examine the differences in the reaction of asset prices to rare disaster risk between commodity and financial assets. We first employ time-varying parameter VAR (TVP-VAR) models to investigate the role of rare disaster risk in the price dynamics of major asset markets. The results indicate that disaster risk generally has a more intense and persistent impact on crude oil and stock markets when compared to gold and bond markets. However, the role of rare disaster risk differs substantially between commodity and financial assets, as well as between the short and long term. Moreover, when using a nonparametric causality-in-quantiles method to detect causal relationships, we provide evidence of the nonlinear causality effect of rare disaster risks on asset volatilities, and not their returns, except for crude oil. In addition, we demonstrate that augmenting a diversified portfolio of stock or bonds with gold can significantly increase its risk-adjusted performance. The findings have important implications for investors as well as policymakers.
Highlights
Rare disaster risks, such as economic depressions or international conflicts and wars, constitute one of the main determinants of asset risk premium [1]
We further compare the differences in the effects of rare disaster risks between commodity and financial assets
We use basic VAR and time-varying parameter VAR (TVP-VAR) approaches to examine the responses of various asset markets to the shock of rare disaster risk, as well as to quantify the proportion of asset market volatility attributed to rare disaster risk
Summary
Rare disaster risks, such as economic depressions or international conflicts and wars, constitute one of the main determinants of asset risk premium [1]. The probability of timevarying rare disasters might provide explanations for equity premium and high-volatility puzzles, and risk-free rate puzzles, as well as asset predictability [2], which is of great importance in asset allocation and risk management. Since Rietz proposes a theoretical discussion on the role of a market crash in explaining the equity risk premium puzzle [1], the theoretical modeling of the impact of rare disaster risk on asset price dynamics has often been discussed for equity markets, such as the equity premium puzzle [3,4], excess return predictability [3,4,5,6], and excess equity volatility [4,7], etc. Some studies have attempted to model the impact of rare disaster risk on other assets, including bonds [4,8], commodities [9], and exchange rates [10], among others
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