Traditional disaster models with time-varying disaster risk are not perfect in explaining asset returns. We redefine rare economic disasters and develop a novel disaster model with long-run disaster risk to match the asset return moments observed in the U.S. data. The difference from traditional disaster models is that our model contains the long-run disaster risk by treating the long-run ingredient of consumption growth as a function of time-varying disaster probability. Our model matches the U.S. data better than the traditional disaster model with time-varying disaster risk. This study uncovers an additional channel through which disaster risk affects asset returns and bridges the gap between long-run risk models and rare disaster models.
Copyright: © 2023 Fan, Xiao. This is an open access article distributed under the terms of the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original author and source are credited.