Does the investment market consider the consideration of catastrophic risk in Equity Risk Premium?
While the likelihood of a macroeconomic catastrophe is not high, it still occurs periodically. During these times, economic activity slows significantly, assets depreciate, and investors almost entirely withdraw…
A study spanning 100 years across 24 countries (Barro, Nakamura, Steinsson, and Ursua; 2009) shows that the average duration of catastrophes is 6 years, and only the perception of downturns also tends to last a long time, exacerbating*.
Similarly, results from an examination of 87 severe crises from 1870 to 2007 (Barro and Ursua, 2009) show that the negative impact of catastrophes on stock prices averages 22%, and the risk premium on capital should still have been around 7%, indicating that certain risks were underestimated*.
I believe 7% is a very high figure for this portion of risk alone. As it seems, the investment market here is dominated by excessive optimism and fails to fully consider catastrophic risks…
*Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2013 Edition Updated: March 2013; Aswath Damodaran; Stern School of Business