1 / 23

Rare Disasters and Asset Markets in the Twentieth Century

Rare Disasters and Asset Markets in the Twentieth Century. Barro QJE, 2006 Presentation by Serdar Aldatmaz Spring, 2010. Background. Mehra-Prescott, 1985 Equity premium puzzle Rietz, 1988 Low-probability economic disasters might be the solution. Preview of Results.

yoland
Download Presentation

Rare Disasters and Asset Markets in the Twentieth Century

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Rare Disasters and Asset Markets in the Twentieth Century Barro QJE, 2006 Presentation by Serdar Aldatmaz Spring, 2010

  2. Background • Mehra-Prescott, 1985 • Equity premium puzzle • Rietz, 1988 • Low-probability economic disasters might be the solution

  3. Preview of Results • Inclusion of rare disasters into Mehra and Prescott’s model can explain asset-market puzzles • Equity-premium puzzle • Low real rate of return on government bills • Low expected real interest rates during major wars

  4. Outline • The Model • Review of economic disasters • Calibration Results • Extensions • Concluding Remarks

  5. The Model • Lucas Tree Model • Exogenous, stochastic production • Neither investment, nor depreciation • Allows for capital formation in the extension • Consumption equals output • Two assets • Equity claim on t+1 output • Risk-free asset, which partially defaults in disasters

  6. Solution without Rare Disasters • Solving for the agent’s maximizationproblem;

  7. Modelling Rare Disasters • ut+1 is i.i.d w/ N(0, σ2) • σ and γare known • p is the probability of disaster (constant) • b is the size of contraction in case of a disaster

  8. Modelling Default • Default occurs with probability qwhen a v-type disaster occurs • Default wipes out the fraction d of the return on the government bill • Default does not affect equities and real GDP

  9. Solution of the Model - Price • Price of one-period equity claim:

  10. Solution of the Model - Returns • Expected rate of return on one-period equity:Et(Ret+1)=Et(At+1)/Pt1 • Return on government bills: (Assumption: d=b)

  11. Solution of the Model - Equity Premium • The difference between the two returns: • Increasing in p & θ & b=d • Decreasing in q

  12. Outline • The Model • Review of economic disasters • Calibration • Extensions • Concluding Remarks

  13. Economic Disasters

  14. Stock and Bill Returns

  15. Outline • The Model • Review of economic disasters • Calibration • Extensions • Concluding Remarks

  16. Calibration of Disaster Parameters • Probability of disasters • 60 occurrences for 35 countries over 100 years • p = 1.7% • Distribution of b from realized contractions • Default probability • 25 partial defaults out of 60 events • q = 40%

  17. Calibration of Other Parameters • σ = 0.02 • γ = 0.025 • ρ = 0.03 • θ = 3 or 4

  18. Calibration Results

  19. What other puzzles can be explained? • Why do expected real interest rates fall during wars? • Perceived probability, p, of future economic disaster increases

  20. Outline • The Model • Review of economic disasters in the twentieth century • Calibration • Extensions • Concluding Remarks

  21. Duration and Capital Formation • Main results do not change when we allow for finite and various length disasters • When we incorporate capital formation, invested and depreciation, the model still predicts similar equity premium results based on the calibration

  22. Outline • The Model • Review of economic disasters in the twentieth century • Calibration • Extensions • Concluding Remarks

  23. Concluding Remarks • Low-probability disasters explain the equity premium puzzle along with other asset market puzzles • Future research • Incorporate stochastic variations in p • Option prices, insurance premiums, prices of gold etc. • Relax i.i.d assumptions

More Related