Article,

Time-Varying Rare Disaster Risk and Stock Returns

, , and .
Journal of Financial Economics, 101 (2): 313-332 (2011)
DOI: http://dx.doi.org/10.1016/j.jfineco.2011.02.019

Abstract

This study provides empirical support for theoretical models that allow for time-varying rare disaster risk. Using a database of 447 international political crises during the period 1918–2006, we create a crisis index that shows substantial variation over time. Changes in this crisis index, our proxy for changes in perceived disaster probability, have a large impact on both the mean and volatility of world stock market returns. Crisis risk is positively correlated with the earnings–price ratio and the dividend yield. Cross-sectional tests also show that crisis risk is priced: Industries that are more crisis risk sensitive yield higher returns.

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