Asset Pricing with Endogenous Disasters

Abstract

We propose a model with endogenous disasters generated through a labor dynamics mechanism. The model is parsimonious, having only one continuous state variable as well as CRRA agents with reasonable risk aversion. In such a simple setting we solve for prices in closed form and show that we can account for the high equity premium and volatility observed in the U.S. stock market as well as for a low riskfree rate. Excess returns and volatility are predictable and dividend yields implied by our model constitute stronger predictors than the observed dividend yield or cay. Having generated disasters through a labor mechanism, we are able to validate our model by calibrating it to labor-specific data, such as labor's share of income, while testing its asset pricing predictions, such as the magnitude of the consumption drop in an economic collapse.

Keywords: Disaster, Peso effect, Asset Pricing, Productivity

JEL Classification: G12