Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?

70 Pages Posted: 10 Oct 2008

See all articles by Jessica A. Wachter

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

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Date Written: October 2008

Abstract

Why is the equity premium so high, and why are stocks so volatile? Why are stock returns in excess of government bill rates predictable? This paper proposes an answer to these questions based on a time-varying probability of a consumption disaster. In the model, aggregate consumption follows a normal distribution with low volatility most of the time, but with some probability of a consumption realization far out in the left tail. The possibility of this poor outcome substantially increases the equity premium, while time-variation in the probability of this outcome drives high stock market volatility and excess return predictability.

Suggested Citation

Wachter, Jessica A., Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility? (October 2008). NBER Working Paper No. w14386, Available at SSRN: https://ssrn.com/abstract=1278459

Jessica A. Wachter (Contact Author)

University of Pennsylvania - Finance Department ( email )

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