Date of this Version
Annual Review of Financial Economics
After lying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this article, we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability, and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing as well as the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.
Posted with permission from the Annual Review of Financial Economics, Volume 7© by Annual Reviews, http://www.annualreviews.org.
rare events, fat tails, equity premium puzzle, volatility puzzle
Tsai, J., & Wachter, J. A. (2015). Disaster Risk and Its Implications for Asset Pricing. Annual Review of Financial Economics, 7 219-252. http://dx.doi.org/10.1146/annurev-financial-111914-041906
Date Posted: 27 November 2017
This document has been peer reviewed.