Finance Seminar with Ilaria Piatti, University of Lugano

The Department of Finance is proud to announce the upcoming seminar with Ilaria Piatti, University of Lugano.

Ilaria Piatti will present:

Heterogeneous Beliefs about Rare Event Risk in the Lucas Orchard

Abstract:

This paper investigates the asset pricing implications of investor disagreement about the likelihood of a systemic disaster. I specify a general equilibrium Lucas endowment economy with multiple trees and heterogeneous beliefs about the risk of rare systemic events; the aim is to understand how risksharing 
mechanisms and fear affect equity and variance risk premia, at an aggregate level and in the cross section of stock returns. I first identify a state-dependent conditional link between equity and variance premia, that changes with the cross-sectional distribution of agent consumption. Second, although the risk-neutral stock returns correlation is increasing in the share of pessimistic agents, the correlation computed under the objective measure is not; the result is a countercyclical correlation risk premium. Third, as the number of assets increases, the aggregate variance premium is driven almost entirely by fear of systemic disasters. Empirically, I find that, as anticipated by the model, the variance premium’s power to predict future excess returns is greater during times of financial distress, which typically feature more disagreement among investors. This result holds especially for small stocks, which are more sensitive to systemic rare event risk.