On the effects of rare disasters and uncertainty shocks for risk premia in non-linear DSGE models

• Published in: Review of economic dynamics 2012-07, Vol.15 (3), p.295-316
• Main Author: Andreasen, Martin M.
• Format: Article
• Language: English
• Subjects: Disasters; Economic equilibrium models; Economic models; Epstein–Zin–Weil preferences; GARCH; GARCH models; Keynesian theory; Rare disasters; Risk; Risk premia; Risk premiums; Stochastic processes; Stochastic volatility; Studies; Total factor productivity; Uncertainty; Volatility
• ISSN: 1094-2025; 1096-6099
• DOI: 10.1016/j.red.2011.08.001

This paper studies how rare disasters and uncertainty shocks affect risk premia in DSGE models approximated to second and third order. Based on an extension of the results in Schmitt-Grohé and Uribe (2004) to third order, we derive propositions for how rare disasters, stochastic volatility, and GARCH affect any type of risk premia in a wide class of DSGE models. To quantify the effects, we set up a standard New Keynesian DSGE model where total factor productivity includes rare disasters, stochastic volatility, and GARCH. We find that rare disasters increase the level of the 10-year nominal term premium, whereas a key effect of uncertainty shocks, i.e. stochastic volatility and GARCH, is an increase in the variability of this premium. ► Non-normal shocks affect all premia in DSGE models at second and third order. ► Rare disasters influence the level of risk premia at third order. ► Stochastic volatility and GARCH affect the level and variance at third order. ► These effects for the 10-year term premium are shown in a New Keynesian model.