Rare Disasters and the Equity Premium in a Two-Country World

20 Pages Posted: 5 Mar 2007

See all articles by Laurence Copeland

Laurence Copeland

Cardiff University - Cardiff Business School

Yanhui Zhu

Cardiff University - Cardiff Business School - Economics Section

Abstract

We extend the Barro (2006) closed-economy model of the equity risk premium in the presence of extreme events ("disasters") to a two-country world. In this more general setting, both the output risk of rare disasters and the associated risk of a default on Government debt, can be diversified. The extent to which agents in one country can diversify away the risk of extreme events depends on the relative size of the two countries, and critically on the probability of a disaster in one country conditional on a disaster in the other. We show that, using Barro's own calibration in combination with a broad range of plausible values for the additional parameters, the model implies levels of the equity risk premium far lower than those typically observed in the data. We conclude that the model cannot explain the equity risk premium.

Keywords: equity risk premium, default risk, international diversification

JEL Classification: F3, G1

Suggested Citation

Copeland, Laurence S. and Zhu, Yanhui, Rare Disasters and the Equity Premium in a Two-Country World. Available at SSRN: https://ssrn.com/abstract=968080 or http://dx.doi.org/10.2139/ssrn.968080

Laurence S. Copeland (Contact Author)

Cardiff University - Cardiff Business School ( email )

Aberconway Building
Colum Drive
Cardiff, CF10 3EU
United Kingdom
+44 29 20875740 (Phone)
+44 29 20874419 (Fax)

Yanhui Zhu

Cardiff University - Cardiff Business School - Economics Section ( email )

Cardiff CF10 3EU
United Kingdom

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