Rare Disasters and the Equity Premium in a Two-Country World

Abstract Rare Disasters and the Equity Premium,in a Two-Country World Laurence Copeland,and Yanhui Zhu We extend,the Barro (2006) closed-economy,model,of the equity risk premium,in the presence of extreme events ("disasters") to a two-country world. In this more general setting, both the output,risk of rare disasters and the associated risk of a default on Government debt, can be diversi…ed. The extent to which agents in one country can diversify away the risk of extreme events depends on the relative size of the two countries, and critically on the probability of a disaster in one country conditional on a disaster in the other. We show that, using Barro’s own calibration in combination,with a broad range of plausible values for the additional parameters, the model implies levels of the equity risk premium far lower than