Empirical Asset Pricing with Multi-Period Disasters and Partial Government Defaults

According to the rare disaster hypothesis, the extraordinary mean excess returns on U.S. equity portfolios during the postwar period resulted because investors ex ante demanded a compensation for possibly disastrous but very unlikely risks that they ex post did not incur. Empirical tests of the rare disaster hypothesis are scarce, and the frequently used assumption that disasters shrink to one-period events is under suspicion of being the driving force behind the hypothesis' success in calibrations. This study proposes a simulation-based approach to estimate an asset pricing model that accounts for multi-period disasters, partial government defaults, and recursive investor preferences. The empirical results corroborate that the rare disaster hypothesis helps to restore the nexus between the real economy and financial markets that is implied by the consumption-based asset pricing paradigm. The estimates of the subjective discount factor, relative risk aversion, and the intertemporal elasticity of substitution are economically reasonable, rather precise, and robust with respect to alternative model specifications. Moreover, the model-implied equity premium, mean T-bill return, and market Sharpe ratio are plausible and consistent with empirical data