Time-Varying Rare Disasters, Model Uncertainty, and the Equity Premium Puzzle
Year: 2026
Type: article
Abstract: This study develops a production-based asset pricing model that incorporates time-varying disaster risk together with model uncertainty. Within an extended relative-entropy framework, agents’ distorted beliefs and ambiguity aversion are characterized, and the corresponding Hamilton–Jacobi–Bellman–Isaacs (HJBI) equation is derived under a stochastic robust-control setting. The framework implies that the equity premium can be decomposed into three components: diffusion and jump risk premiums associated with conventional risk aversion and an additional rare-event premium generated by ambiguity aversion. Numerical experiments show that ambiguity aversion reduces the equilibrium risk-free rate, whereas aversion to rare disasters significantly raises compensation for bearing risk, helping reconcile both the equity premium puzzle and the risk-free rate puzzle. In addition, equity return volatility increases with the probability of disaster events, but at a diminishing rate. Overall, the results underscore the importance of model uncertainty and time-varying disaster risk in the determination of asset prices and risk premia.
Source: Mathematics
DOI: 10.3390/math14111791
Authors: Yuzhuo Ren, Weiqi Liu
Institution: Shanxi University
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: gold
Estimated APC paid: $3,137
OpenAlex ID: W7162134255
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