51 Pages Posted: 18 Mar 2017
Date Written: October 1, 2016
Rare events (RE) and long-run risks (LRR) are complementary approaches for characterizing macroeconomic variables and for understanding asset pricing. We estimate a model with RE and LRR using long-term consumption data for 42 economies. RE typically associates with major historical episodes, such as world wars and depressions and analogous country-specific events. LRR reflects gradual processes that influence long-run growth rates and volatility. A match between the model and observed average rates of return requires a coefficient of relative risk aversion, γ, around 6. Most of the explanation for the equity premium derives from RE, although LRR makes a moderate contribution.
Keywords: rare events, long-run risks, asset pricing, risk aversion
JEL Classification: G12, G17, E21, E32, E44
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