Time-Varying Rare Disaster Risk and Stock Returns

64 Pages Posted: 18 Mar 2010 Last revised: 12 Oct 2010

Henk Berkman

University of Auckland - Business School

Ben Jacobsen

Tilburg University - TIAS School for Business and Society; New Zealand Institute of Advanced Study

John B. Lee

University of Auckland

Date Written: august 15, 2010

Abstract

This study provides empirical support for recent theoretical models that allow for time-varying rare disaster risk. Using a unique database of 447 international political crises during the period 1918–2006, we create a crisis index that shows substantial variation over time. We show that changes in this crisis index, our proxy for changes in perceived disaster probability, have a statistically significant and economically large impact on both the mean and volatility of world stock market returns. World markets react more strongly when crises are more severe and when there is more at stake due to the involvement of major powers. Using predictive regressions, there is no significant relation between crisis risk and future market returns, however crisis risk is positively correlated with the earnings-price ratio and the dividend yield. Cross-sectional tests provide further support for the hypothesis that crisis risk is priced: US industries with higher crisis risk sensitivity generate a higher excess return. Our crisis measures also correlate negatively with U.S. consumer confidence and GDP-growth forecasts, both proxies for expected U.S. consumption growth.

Keywords: Equity Premium, Volatility, Rare Disasters, International Political Crises, Consumption

Suggested Citation

Berkman, Henk and Jacobsen, Ben and Lee, John B., Time-Varying Rare Disaster Risk and Stock Returns (august 15, 2010). Available at SSRN: https://ssrn.com/abstract=1572042 or http://dx.doi.org/10.2139/ssrn.1572042

Henk Berkman

University of Auckland - Business School ( email )

Private Bag 92019
Room: 577
Auckland
New Zealand
(64 9) 3737599 Ext. 7181 (Phone)
(64 9) 3737406 (Fax)

Ben Jacobsen

Tilburg University - TIAS School for Business and Society ( email )

Warandelaan 2
TIAS Building
Tilburg, Noord Brabant 5037 AB
Netherlands

New Zealand Institute of Advanced Study ( email )

Auckland
New Zealand

John B. Lee (Contact Author)

University of Auckland ( email )

Private Bag 92019
Auckland, 1001
New Zealand
649 373 7599 ext. 85171 (Phone)
649 373 7406 (Fax)

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