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Thursday, June 11, 2015

'Disaster Risk and Asset Pricing'

Jerry Tsai and Jessica Wachter at Vox EU:

Disaster risk and asset pricing, Jerry Tsai, Jessica Wachter, Vox EU: A persistently puzzling feature of the US stock market is the high return to holding a diversified equity portfolio. On average, over the last 60 years, equities have outperformed short-term bonds by 7.5% a year. The difference, when cumulated over time, is dramatic. ...$1 invested in 1947 in a value-weighted portfolio of equities traded on major exchanges would have increased 100-fold (in 1947 dollars), while a strategy of rolling over short-term Treasury bills would have barely kept up with inflation. The 2008 Global Crisis resulted in a very temporary dip in this performance. ...
Why do equities earn such a high rate of return?
The most obvious possibility is that this high return is a compensation for risk. However, while equity markets are very risky (the standard deviation of the above portfolio is 18% per year), this risk is not reflected in the broader economy. For long-run investors who are willing to ride out the ups and downs of the stock market, the risk that matters is the risk in actual consumption. And that standard deviation has historically been less than 2% a year, even when taking the Great Recession into account. This disconnect between the return to holding stocks and the risk of the overall economy, is known as the equity premium puzzle (Mehra and Prescott 1985).
In a recent article (Tsai and Wachter 2015), we argue that this equity premium reflects the risk of an economy-wide disaster. Our argument builds on work by Robert Barro (2006), further developed with co-authors Emi Nakamura, John Steinssen and Jose Ursua (Barro and Ursua 2008, Nakamura et al. 2011). ...
Once we account for the possibility of rare disasters, the equity premium is no longer a puzzle. High equity returns do not represent a ‘free lunch’ in which investors receive high returns without taking on risk. On the other hand, equities do not represent something that prudent investors should avoid. Rather high returns on equities reward investors for bearing the risk of a large decline in stock prices during an economic disaster.
Stock market volatility
Another basic question about the stock market pertains to the level of volatility. Various studies, beginning with Shiller (1981) have concluded that the volatility in the stock market is too great to represent forecasts of future dividends or other measures of cash flows of corporations. As memorably described by Shiller, the stock market appears to exhibit ‘excess’ volatility, namely volatility that cannot be attributed to rational factors and rather reflects (in the words of Keynes) the ‘animal spirits’ of investors. 
Rare disaster models offer an alternative way to understand excess volatility. Rather than reflecting the day-to-day whims of investors, stock market fluctuations could reflect investors' changing views of the probability of a rare disaster..., stock returns, which incorporate these probabilities, can be far more volatile than dividends or consumption, which reflect (primarily) the disaster itself. ...
Low interest rates
As is well-known, the Global Crisis and its aftermath have been characterised by interest rates that are extremely low by historical standards. ... Of course, many factors influence interest rates. However, the same model that can explain a high equity premium and high stock market volatility, can also explain this seemingly anomalous interest rate behaviour. When the risk of a rare disaster rises, investors want to save to protect their assets for the future. This lowers the required return on savings, namely the interest rate, even as it raises the implicit rate of return on equities. This could contribute to the challenge facing central banks when conducting monetary policy. According to this view, raising interest rates may not be a matter of a simple policy decision, and may require the far-harder task of altering investors' perceptions of risk. ...
Conclusion
Recent research demonstrates how rare disasters can explain both a high equity premium and high stock market volatility. Time-varying disaster risk offers a compelling explanation for the patterns in equity values, consumption, and interest rates during the recent Global Crisis and its aftermath. While significant attention has rightly been paid to reducing or eliminating risk in the aftermath of the Crisis, research on disasters suggests that this is a risk that, to some extent, has long been present and accounted for in equity markets. While policymakers struggle with strategies to avoid crises, investors may have decided that a risk of a crisis can never be truly eliminated, and have acted accordingly. ...

    Posted by on Thursday, June 11, 2015 at 11:27 AM in Economics, Financial System | Permalink  Comments (39)


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