Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?
Jessica A. Wachter
University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)
August 7, 2012
Journal of Finance, Forthcoming
AFA 2011 Denver Meetings Paper
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.
Number of Pages in PDF File: 70
Keywords: Rare disasters, Peso problem, Excess volatility
JEL Classification: G12
Date posted: March 18, 2010 ; Last revised: August 8, 2012