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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/28349
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| Title: | Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance |
| Authors: | Gabaix, Xavier |
| Issue Date: | 1-Dec-2009 |
| Series/Report no.: | FIN-09-29 |
| Abstract: | This paper incorporates a time-varying intensity of disasters in the
Rietz-Barro hypothesis that risk premia result from the possibility of
rare, large disasters. During a disaster, an asset’s fundamental
value falls by a time-varying amount. This in turn generates
time-varying risk premia and thus volatile asset prices and return
predictability. Using the recent technique of linearity-generating
processes (Gabaix 2007), the model is tractable, and all prices are
exactly solved in closed form. In the “variable rare
disasters” framework, the following empirical regularities can be
understood qualitatively: (i) equity premium puzzle (ii) risk-free
rate-puzzle (iii) excess volatility puzzle (iv) predictability of
aggregate stock market returns with price-dividend ratios (v) value
premium (vi) often greater explanatory power of characteristics than
covariances for asset returns (vii) upward sloping nominal yield curve
(viiii) a steep yield curve predicts high bond excess returns and a fall
in long term rates (ix) corporate bond spread puzzle (x) high price of
deep out-of-the-money puts. I also provide a calibration in which those
puzzles can be understood quantitatively as well. The fear of disaster
can be interpreted literally, or can be viewed as a tractable way to
model time-varying risk-aversion or investor sentiment. (JEL: E43, E44, G12) |
| URI: | http://hdl.handle.net/2451/28349 |
| Appears in Collections: | Finance Working Papers
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