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Rare disasters and the equity premium in a two-country world

Copeland, Laurence Sidney and Zhu, Yanhui 2007. Rare disasters and the equity premium in a two-country world. [Working Paper]. Working Paper Series, Social Science Electronic Network. Available at:

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We extend the Barro (2006) closed-economy model of the equity risk premium in the presence of extreme events ("disasters") to a two-country world. In this more general setting, both the output risk of rare disasters and the associated risk of a default on Government debt, can be diversified. The extent to which agents in one country can diversify away the risk of extreme events depends on the relative size of the two countries, and critically on the probability of a disaster in one country conditional on a disaster in the other. We show that, using Barro's own calibration in combination with a broad range of plausible values for the additional parameters, the model implies levels of the equity risk premium far lower than those typically observed in the data. We conclude that the model cannot explain the equity risk premium.

Item Type: Monograph (Working Paper)
Date Type: Publication
Status: Published
Schools: Business (Including Economics)
Subjects: H Social Sciences > HG Finance
Uncontrolled Keywords: equity risk premium, default risk, international diversification
Publisher: Social Science Electronic Network
Last Modified: 04 Jun 2017 04:29

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