Rare Booms and Disasters in a Multi-sector Endowment Economy

Abstract

Why do value stocks have higher average returns than growth stocks, despite having lower risk? Why do these stocks exhibit positive abnormal performance, while growth stocks exhibit negative abnormal performance? This paper offers a rare-event-based explanation that can also account for the high equity premium and volatility of the aggregate market. The model explains other puzzling aspects of the data, such as joint patterns in time-series predictablity of aggregate market and value and growth returns, long periods in which growth outperforms value, and the association between positive skewness and low realized returns. Patterns in time-series predictability offer independent evidence for the model's conclusions.

Good and bad uncertainty: Macroeconomic and financial market implications

“…This effect on prices is also reflected in Colacito et al (2013) who show that asset valuations decline when skewness becomes more negative. Tsai and Wachter (2014) consider a specification that incorporates time-varying rare disasters and booms. As their Poisson jump shocks are uncompensated, the intensities of booms and disasters have a direct impact on expected growth and thus capture the differential τ effects highlighted above, which leads to a differential impact of jump intensity on prices.…”

“…One analytically convenient specification that our framework accommodates and which is widely used features Poisson jumps in consumption dynamics (see, e.g., Eraker and Shaliastovich, 2008;Benzoni et al, 2011;Drechsler and Yaron, 2011;and Tsai and Wachter, 2014 for recent examples). In another specification, which again can be accommodated within our framework, the cash flow shocks are drawn from a Gamma distribution with a time-varying shape parameter, in which case the consumption shock dynamics follow the good and bad environment specification in Bekaert and Engstrom (2009).…”

Good and Bad Variance Premia and Expected Returns

“…The probabilities of good and bad jumps vary over time and are driven by distinct processes. Our specification of consumption dynamics is related to Segal, Shaliastovich, and Yaron (2015) and Tsai and Wachter (2014), who also use Poisson jumps with separate intensities to isolate the variation in upward and downward moves in the fundamentals. It is also closely related to the good and bad environments specification of Bekaert and Engstrom (2009).…”

“…Bekaert and Engstrom (2009) consider a habit formation model with distinct variation in the volatilities of positive and negative Gamma shocks to fundamentals to address several stylized asset pricing puzzles, including the predictability of returns by the total variance premium. Tsai and Wachter (2014) construct a model with distinct time variation in the probabilities of rare booms and disasters to explain the value premium. Our model integrates the economic channels used in this literature in a parsimonious way, focusing on the novel empirical evidence for a link between the good and bad variance premia and expected returns.…”

The Dynamics of Crises and the Equity Premium

“…Wachter (2013) proposes a time-varying probability of rare disasters which can explain the high stock market volatility. Tsai and Wachter (2014) apply this model to growth and value stocks.…”