Learning with Rare Disasters

64 Pages Posted: 25 Jun 2019 Last revised: 5 Sep 2019

See all articles by Jessica A. Wachter

Jessica A. Wachter

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

Yicheng Zhu

University of Pennsylvania - Finance Department

Date Written: September 5, 2019

Abstract

Financial crises appear to have long-lasting effects, even after the crisis itself has past. This paper offers a simple explanation through Bayesian learning from rare events. Agents face a latent and time-varying probability of economic disaster. When a disaster occurs, learning results in greater effects on asset prices because agents update their probability of future disasters. Moreover, agents' belief that the disaster risk is high can rationally persist for years, even when it is in fact low. We generalize the model to allow for a noisy signal of the disaster probability. This generalized model explains excess stock market volatility together with negative skewness, effects that previous models in the literature struggle to explain.

Suggested Citation

Wachter, Jessica A. and Zhu, Yicheng, Learning with Rare Disasters (September 5, 2019). Available at SSRN: https://ssrn.com/abstract=3407397 or http://dx.doi.org/10.2139/ssrn.3407397

Jessica A. Wachter (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-7634 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Yicheng Zhu

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

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