Slowly Unfolding Disasters
60 Pages Posted: 9 Aug 2019 Last revised: 19 Dec 2019
Date Written: October 17, 2019
We develop a model that endogenously generates slowly unfolding disasters not only in the macroeconomy, but also in financial markets. In our model, investors cannot exactly distinguish whether the economy is experiencing a mild/temporary downturn or is on the verge of a severe/prolonged disaster. Due to imperfect information, disaster periods are not fully identified by investors ex ante at the onset, but ex post using the peak-to-trough approach as in the data. Bayesian learning induces equity prices to gradually react to persistent consumption declines in periods of disasters. We show that modeling realistic equity dynamics during disasters is crucial to explaining the VIX, variance risk premium, and risk premia on put-protected portfolios, addressing the shortcomings and criticisms of traditional disaster risk models.
Suggested Citation: Suggested Citation