Abstract
I analyze a rare disasters economy that yields a measure of the risk neutral probability of a macroeconomic disaster, p*t . A large panel of options data provides strong evidence that p*t is the single factor driving option-implied jump risk measures in the cross section of firms. This is a core assumption of the rare disasters paradigm. A number of empirical patterns further support the interpretation of p*t as the risk-neutral likelihood of a disaster. First, standard forecasting regressions reveal that increases in p*t lead to economic downturns. Second, disaster risk is priced in the cross section of U.S. equity returns. A zero-cost equity portfolio with exposure to disasters earns risk-adjusted returns of 7.6% per year. Finally, a calibrated version of the model reasonably matches the: (i) sensitivity of the aggregate stock market to changes in the likelihood of a disaster and (ii) loss rates of disaster risky stocks during the 2008 financial crisis.
Highlights
A longstanding puzzle in macroeconomics and financial economics is that consumption growth is not volatile enough to justify why the aggregate stock market earns large returns in excess of riskless bonds
Rietz (1988) and Barro (2006) argue that the economy is subject to rare “disasters” such as wars and depressions; in turn, the risk premium on stocks is not surprising because stocks are highly exposed to these rare events
This paper provides evidence of a single factor that drives the cross section of option-implied jump risk
Summary
A longstanding puzzle in macroeconomics and financial economics is that consumption growth is not volatile enough to justify why the aggregate stock market earns large returns in excess of riskless bonds. The core assumption of rare disaster models is that all assets in the economy are exposed to an aggregate jump-risk factor If this is the case, time-series variation in the tails of individual asset returns should be driven by this single factor, even though cross-sectionally some assets are more exposed to the tail event than others. The rare disasters paradigm makes a strong prediction for how time-series variation in the probability of disaster relates to the cross-sectional performance of stocks. In the final part of the paper, I make stronger assumptions about the mean frequency and severity of disasters, as well as preferences This allows me to quantitatively compare a calibrated version of the model to aggregate stock market movements and the cross section of equity returns. 51% of their value, though many of these stocks benefited from the unprecedented intervention of the government into U.S capital markets
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have