Volatility Clustering through Different Perceived Business Cycle's Lengths
Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute
October 5, 2011
We consider a pure exchange economy populated by 2 agents who filter out the unobservable fundamental. Agents incur different beliefs, because they disagree on the length of the business cycle. We explain both the level and the dynamics of the stock market volatility in close connection with the state of the economy. The stock market volatility is countercyclical and significantly higher than the consumption volatility. We highlight the endogenous mechanism that generates our results: A persistent fundamental, along with distinct perceptions of the length of the business cycle, implies a persistent disagreement among agents. Then, the disagreement affects the diffusion of the state price density and consequently the market volatility through the diffusion of the sentiment variable. Thanks to Malliavin calculus, we show that the disagreement process is the sole driver of the market volatility dynamics.
Number of Pages in PDF File: 48working papers series
Date posted: July 3, 2010 ; Last revised: October 5, 2011
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