Heterogeneous Beliefs about Rare Event Risk in the Lucas Orchard

This paper investigates the asset pricing implications of investor disagreement about the likelihood of a systematic disaster. I specify a general equilibrium model with multiple trees and heterogeneous beliefs about rare event risk, to understand how risk-sharing mechanisms affect equity and variance risk premia, at an aggregate level and in the cross-section of stock returns. I identify a state dependent link between equity and variance premia, that changes with the distribution of agent consumption. Empirically, as in the model, the variance premium’s predictive power for future excess returns is greater during times of financial distress, mainly for small stocks.