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Consumption-based asset pricing with rare disaster risk

Author

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  • Grammig, Joachim
  • Sönksen, Jantje

Abstract

The rare disaster hypothesis suggests that the extraordinarily high postwar U.S. equity premium resulted because investors ex ante demanded compensation for unlikely but calamitous risks that they happened not to incur. Although convincing in theory, empirical tests of the rare disaster explanation are scarce. We estimate a disaster-including consumption-based asset pricing model (CBM) using a combination of the simulated method of moments and bootstrapping. We consider several methodological alternatives that differ in the moment matches and the way to account for disasters in the simulated consumption growth and return series. Whichever specification is used, the estimated preference parameters are of an economically plausible size, and the estimation precision is much higher than in previous studies that use the canonical CBM. Our results thus provide empirical support for the rare disaster hypothesis, and help reconcile the nexus between real economy and financial markets implied by the consumption-based asset pricing paradigm.

Suggested Citation

  • Grammig, Joachim & Sönksen, Jantje, 2014. "Consumption-based asset pricing with rare disaster risk," CFS Working Paper Series 480, Center for Financial Studies (CFS).
    • Handle: RePEc:zbw:cfswop:480
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    References listed on IDEAS

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    More about this item

    Keywords

    equity premium; rare disaster risk; asset pricing; simulated method of moments;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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