Asset pricing with long-run disaster risk

Abstract

Traditional disaster models with time-varying disaster risk are not perfect in explaining asset returns. We redefine rare economic disasters and develop a novel disaster model with long-run disaster risk to match the asset return moments observed in the U.S. data. The difference from traditional disaster models is that our model contains the long-run disaster risk by treating the long-run ingredient of consumption growth as a function of time-varying disaster probability. Our model matches the U.S. data better than the traditional disaster model with time-varying disaster risk. This study uncovers an additional channel through which disaster risk affects asset returns and bridges the gap between long-run risk models and rare disaster models.