The impact of rare disasters on equity premium and term premium in a New Keynesian DSGE model is explored in the thesis. Andreasen's (2012) model with Epstein-Zin preferences, bonds and a rare disaster shock in total factor productivity process is extended by a variable capital stock and an equity-type asset. We find that the variable capital significantly changes behavior of the model, capital depreciation must be substantially increased to counter the effect of variable capital and stochastic mean of inflation increases. The model calibrated to the US economy and a high risk aversion generates 10-year term premium of 90 basis points, rare disasters increase the premium only by 3 basis points. The equity premium is 163 basis points and rare disasters increase it also only by 3 basis points. The model with a low coefficient of relative risk aversion of 5.5 generates negative risk premia. Rare disasters increase the risk premia by mere 4 basis points in comparison to a model with i.i.d. shocks. Powered by TCPDF (www.tcpdf.org)

Understanding the Equity Risk Premium (ERP) and the factors affecting it is cardinal to financial economics, particularly to equity research analysts, domestic and international institutional investors and financial economist. Since the seminal work of Mehra and Prescott (1985) there has been an exponential rise in the research explaining the reasons for ERP puzzle. This review, systematically, investigates the literature related to ERP in four key dimensions. The first dimension is regarding the issues related to different techniques of estimating the ERP. The second dimension is regarding the studies that explain the reasons of existence of the ERP puzzle by making modifications to the preference structures. The third is regarding the macroeconomic variables that help in predicting ERP and the fourth deals with studies that are conducted in the international context. In addition to this, this review meticulously captures some important limitations of the existing literature regarding the estimation of ERP and identifies the domestic and international determinants of ERP, in particular the UK ERP and proposes novel future directions of research. These future research directions have two important implications for my PhD. The first is the academic contribution that predominantly comes from methodological contribution of estimating the ERP. The second is the practical contribution that comes mainly from identifying the unique set of variables (UK domestic and international), which are of prime importance to the domestic and foreign institutional investors because of the financial crisis of 2008-2009 and which should affect the UK ERP.

I propose a rare disaster model of an economy where the probability and intensity of climatic disasters are proxied by CO2 levels that are determined by inputs of carbons from the firms in the economy. Disasters affect the budgets, the labor allocations and investment decisions of households; the production and investment decisions of firms; and, monetary policy. Six propositions are developed relating carbon dioxide and climatic economic damages to financial variables: the risk-free rate, the price dividend ratio, and the risk premium. The six propositions are tested empirically using a unique data set for the United States over the period from March 1958 to December 2018. The data support the six propositions. For the strongest results, the carbon dioxide levels in the atmosphere are negatively related in the long run to the risk-free rate. Carbon dioxide levels are positively related to the risk premium in the long run.