DP8899 Can Rare Events Explain the Equity Premium Puzzle?

Author(s): Anisha Ghosh, Christian Julliard
Publication Date: March 2012
Keyword(s): Calibration, Cross-Section of Asset Returns, Equity Premium Puzzle, Generalized Empirical Likelihood, Peso Phenomenon, Rare Disasters, Rare Events, Semi-parametric Bayesian Inference
JEL(s): C11, C14, E17, G12
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8899

Probably not. First, allowing the probabilities of the states of the economy to differ from their sample frequencies, the Consumption-CAPM is still rejected in both U.S. and international data. Second, the recorded world disasters are too small to rationalize the puzzle unless one assumes that disasters occur every 6-10 years. Third, if the data were generated by the rare events distribution needed to rationalize the equity premium puzzle, the puzzle itself would be unlikely to arise. Fourth, the rare events hypothesis, by reducing the cross-sectional dispersion of consumption risk, worsens the ability of the Consumption-CAPM to explain the cross-section of returns.