Disaster Begets Crisis : The Role of Contagion in Financial Markets ∗ ( Job Market Paper )

Severe economic downturns like the great depression of the 1930s take place over extended periods of time. I model an economy where rare economic disasters increase the likelihood of subsequent near term disasters. The mechanism generates more clustering of disasters than existing models. Serial correlation in disasters has important implications for asset prices. For example, it generates a larger equity premium and a lower risk free rate than similarly calibrated models without this feature. The calibrated model developed here replicates the temporal structure of severe economic downturns in OECD countries. It quantitatively explains the equity premium, the risk-free rate, excess volatility and return predictability. It also generates the implied volatility smile observed in equity index options. ∗I want to thank my dissertation committee Mark Grinblatt (chair), Antonio Bernardo, Hanno Lustig, and Pierre-Olivier Weill. I am also grateful for comments from Bhagwan Chowdhry, Alexander David, Mark Garmaise, Robert Geske, Anisha Ghosh, Benjamin Remy Holcblat, Burton Holifield, Holger Kraft, LarsAlexander Kuehn, Marc Martos-Vila, Emilio Osambela, Ari Pandes, Eduardo Schwartz, Chris Telmer, and seminar participants at the University of Calgary, Carnegie Mellon University, and the UCLA Anderson School of Management. All remaining errors are my own. †UCLA Anderson School of Management, 110 Westwood Plaza Los Angeles, CA 90095, [email protected].