Learning about Rare Disasters: Implications For Consumption and Asset Prices*

Abstract

Rietz (1988) and Barro (2006) subject consumption and dividends to rare disasters in the growth rate. We extend their framework and subject consumption and dividends to rare disasters in the growth persistence. We model growth persistence by means of two hidden types of economic slowdowns: recessions and lost decades.We estimate the model based on the post-war U.S. data using maximum likelihood and find that it can simultaneously match a wide array of dynamic pricing phenomena in the equity and bond markets. The key intuition for our results stems from the inability to discriminate between the short and the long recessions ex ante.

Disaster Risk and Its Implications for Asset Pricing

“…Such a model is solved in closed form by Nowotny (2011). It is also the case that, even if such a clustering is not a property of the physical process of disasters (as it appears to be), it occurs endogenously through learning, as shown by Gillman, Kejak, and Pakoš (2014). Multifrequency processes can produce dynamics that resemble disasters (Calvet and Fisher (2007)).…”

Macroeconomic Disasters and Forward-Looking Consumers: Historical Evidence and Evidence from the COVID-19 Pandemic

“…While there is a large literature that focusses on the asset-pricing implications of macroeconomic disasters (see e.g., Rietz, 1988;Barro, 2006Barro, , 2009Barro and Ursúa, 2012;Nakamura et al, 2013;Gillman et al, 2015;Farhi and Gabaix, 2016), our paper fits in and adds to a growing literature that looks at the behavior of consumption and saving during crises -mostly, conventional recessions -and at the channels through which these crises affect the propensity to consume and save. Mody et al (2012) report large increases in the saving rates of advanced economies during the Great Recession and attribute these increases to changes in variables that capture precautionary saving, i.e., unemployment risk and GDP volatility.…”

Generalized Disappointment Aversion, Learning, and Asset Prices

“…The consumption volatility σ is assumed to be constant, whereas the mean growth rate µ s t+1 is driven by a two-state Markov-switching process s t+1 with the state space S = {1 = expansion, 2 = recession}, 2 Since Hamilton (1989) and Mehra and Prescott (1985), researchers have used these models to embed business cycle fluctuations in the mean growth rates and volatility of consumption growth (Cecchetti, Lam and Mark, 1990;Veronesi, 1999;Ju and Miao, 2012;Johannes, Lochstoer and Mou, 2016;Collin-Dufresne, Johannes and Lochstoer, 2016). By changing the number of states and parameters controling the persistence and conditional distribution of regimes, these models can also embed 'peso problem' in the growth rate (Rietz, 1988;Barro, 2006;Backus, Chernov and Martin, 2011;Gabaix, 2012) or persistence (Gillman, Kejak and Pakos, 2015) of consumption. Additionally, a proper calibration of a regime switching model can match the dynamics of long-run risks in consumption and dividend growth as studied in Tedongap (2011, 2015).…”