Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?
Journal of Finance, Forthcoming
70 Pages Posted: 18 Mar 2010 Last revised: 8 Aug 2012
Date Written: August 7, 2012
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.
Keywords: Rare disasters, Peso problem, Excess volatility
JEL Classification: G12
Suggested Citation: Suggested Citation