On the effects of pessimism toward pollution-driven disasters on equity premiums

This study explores how investors’ subjective perception of pollution-driven disasters affects asset prices. Environmental pollution resulting from economic activities raises the probability of disasters. However, the relationship between economic activity and pollution-driven disasters is difficult to ascertain. Thus, investors make decisions based on subjective expectations; they subjectively evaluate the probability of disasters pessimistically. We investigate whether a pessimistic perception toward pollution-driven disasters causes high equity premiums by deriving a closed-form solution for the equity premium under a Markov process. Our contribution is to demonstrate that pessimism magnifies the equity premium even when the intertemporal elasticity of substitution is slightly lower than 1, which is empirically plausible.