Slowly Unfolding Disasters

60 Pages Posted: 9 Aug 2019 Last revised: 19 Dec 2019

See all articles by Mohammad Ghaderi

Mohammad Ghaderi

University of Houston - C.T. Bauer College of Business

Mete Kilic

University of Southern California - Marshall School of Business

Sang Byung Seo

University of Wisconsin - Madison

Date Written: October 17, 2019

Abstract

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

Ghaderi, Mohammad and Kilic, Mete and Seo, Sang Byung, Slowly Unfolding Disasters (October 17, 2019). Available at SSRN: https://ssrn.com/abstract=3432127 or http://dx.doi.org/10.2139/ssrn.3432127

Mohammad Ghaderi

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Mete Kilic

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA 90089
United States

Sang Byung Seo (Contact Author)

University of Wisconsin - Madison ( email )

975 University Avenue
Madison, WI 53706-1324

HOME PAGE: http://sites.google.com/site/sangbyungseo

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