Disaster Risk and its Implications for Asset Pricing

Posted: 11 Dec 2015

See all articles by Jerry Tsai

Jerry Tsai

Pacific Investment Management Company (PIMCO); University of Oxford - Department of Economics

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: December 2015

Abstract

After lying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this article, we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability, and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing as well as the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.

Suggested Citation

Tsai, Jerry and Wachter, Jessica A., Disaster Risk and its Implications for Asset Pricing (December 2015). Annual Review of Financial Economics, Vol. 7, pp. 219-252, 2015, Available at SSRN: https://ssrn.com/abstract=2702344 or http://dx.doi.org/10.1146/annurev-financial-111914-041906

Jerry Tsai (Contact Author)

Pacific Investment Management Company (PIMCO) ( email )

United States

University of Oxford - Department of Economics ( email )

Manor Road Building
Manor Road
Oxford, OX1 3UQ
United Kingdom

Jessica A. Wachter

University of Pennsylvania - Finance Department ( email )

The Wharton School
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Philadelphia, PA 19104
United States
215-898-7634 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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