Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/102697 
Year of Publication: 
2014
Series/Report no.: 
CFS Working Paper Series No. 480
Publisher: 
Goethe University Frankfurt, Center for Financial Studies (CFS), Frankfurt a. M.
Abstract: 
The rare disaster hypothesis suggests that the extraordinarily high postwar U.S. equity premium resulted because investors ex ante demanded compensation for unlikely but calamitous risks that they happened not to incur. Although convincing in theory, empirical tests of the rare disaster explanation are scarce. We estimate a disaster-including consumption-based asset pricing model (CBM) using a combination of the simulated method of moments and bootstrapping. We consider several methodological alternatives that differ in the moment matches and the way to account for disasters in the simulated consumption growth and return series. Whichever specification is used, the estimated preference parameters are of an economically plausible size, and the estimation precision is much higher than in previous studies that use the canonical CBM. Our results thus provide empirical support for the rare disaster hypothesis, and help reconcile the nexus between real economy and financial markets implied by the consumption-based asset pricing paradigm.
Subjects: 
equity premium
rare disaster risk
asset pricing
simulated method of moments
JEL: 
G10
G12
C58
Document Type: 
Working Paper

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