Consumption booms and disasters in the cross-section of returns

Abstract

We consider an endowment economy with a representative agent with preferences for the early resolution of uncertainty, and where the time-path of consumption is disturbed by rare events (booms and disasters). We show that the time-varying probabilities of disasters are an important state variable in determining asset prices. We build a disaster risk zero-investment mimicking portfolio, that has a 10% annual return and is largely orthogonal to other risk factors, thus generating an alpha of 5.83%. We suggest that disaster risk can also account for part of the size anomaly. We find that the premium associated with disaster risk is positively priced in the cross-section of returns and is able to predict returns at the firm level.

Date of Award	19 Jul 2016
Original language	English
Awarding Institution	Universidade Católica Portuguesa
Supervisor	José Faias (Supervisor)