Variable Rare Disasters: A Tractable Theory of Ten Puzzles in Macro-Finance

Thomas A. Rietz (1988) proposes that the possibility of rare disasters (such as economic depressions or wars) is a major determinant of asset risk premia. Robert J. Barro (2006) shows that, internationally, disasters have been sufficiently frequent and large enough to make the Rietz proposal viable, and they account for a high equity premium. The Rietz-Barro hypothesis is almost always formulated with a constant intensity of disasters, which is fine to analyze the mean equity premium and risk-free rate, but then cannot account for some key features of asset markets, such as volatile price-dividend ratios for stocks, volatile bond risk premia, and return predictability. In Gabaix (2008), some results of which I report here, I formulate a variable-intensity version of the rare disasters hypothesis, and investigate the impact of time-varying disaster intensity on the prices of stocks, bonds, options, and the predictability of their returns. A later companion paper (Emmanuel Farhi and Gabaix 2008) studies exchange rates, and proposes a theory of the forward premium puzzle. In the model, the value loss suffered by assets in a disaster varies both in the cross-section and over time. Hence, assets have time-varying risk premia, which generates volatile prices. When agents are optimistic about stocks (and think they will do reasonably well during disasters), stock premia are low, stock valuations are high, and future returns are low. But this optimism changes over time. This yields a time-varying risk premium which generates a time-varying price-dividend ratio, and “excess volatility” of stock prices. It also makes stock returns predictable via measures such as the dividend-price ratio. Variable Rare Disasters: A Tractable Theory of Ten Puzzles in Macro-Finance