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

Journal of Finance, Forthcoming

AFA 2011 Denver Meetings Paper

70 Pages Posted: 18 Mar 2010 Last revised: 8 Aug 2012

Jessica A. Wachter

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

Multiple version iconThere are 2 versions of this paper

Date Written: August 7, 2012

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.

Keywords: Rare disasters, Peso problem, Excess volatility

JEL Classification: G12

Suggested Citation

Wachter, Jessica A., Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility? (August 7, 2012). Journal of Finance, Forthcoming; AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1572738 or http://dx.doi.org/10.2139/ssrn.1572738

Jessica A. Wachter (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-7634 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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