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The Dynamics of Crises and the Equity Premium

Review of Financial Studies, Vol. 29, pp. 232-270

Authors:
Nicole Branger,
Holger Kraft,
Christoph Meinerding
Research Area:
Systemic Risk Lab, Financial Markets
Date:
Jan 2016
Keywords:
General Equilibrium, Asset Pricing, Recursive Preferences, Long-Run Risk, Disaster Models
Abstract:

It is a major challenge for asset pricing models to generate a high equity premium and a low risk-free rate while imposing realistic consumption dynamics. To address this issue, our paper proposes a novel pricing channel: We allow for consumption drops that can spark an economic crisis. This new feature generates a large equity premium even if possible consumption drops are of moderate size. In turn, our model also matches the consumption data of 42 countries along several dimensions. In particular, our approach generates a realistic number of crises that have realistic durations and involve clustering of moderate consumption drops.

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