The Role of Volatility Shocks and Rare Events in Long-Run Risk Models

60 Pages Posted: 16 Mar 2011

See all articles by Nicole Branger

Nicole Branger

University of Muenster - Finance Center Muenster

Paulo Rodrigues

Maastricht University - Department of Finance

Christian Schlag

Goethe University Frankfurt - Research Center SAFE

Date Written: March 11, 2011

Abstract

We generalize and extend the long-run risk model by Drechsler and Yaron (201'7 by separating the processes for the jump intensity and the stochastic conditional variance. Furthermore we replace their Ornstein-Uhlenbeck specification for the long-run mean of the conditional variance by a square-root process. Although these two modifications seem mainly technical at first sight they have major economic implications and change fundamental characteristics of the model. First they substantially improve the performance of the model in predictive regressions of future excess returns on the current price-dividend ratio and lead to an equity risk premium which is increasing not only with short-run but also with long-run uncertainty. Second, the decoupling of jump intensity and conditional variance permits a detailed analysis which of the effects first shown by Drechsler and Yaron (201'7 are due to the role of the conditional variance as a diffusive factor and which are caused by its second job, namely to control the likelihood of jumps. We find that for most effects generated by the model time-variation in the jump intensity is much more important than diffusive volatility risk.

Keywords: Asset pricing, Epstein-Zin preferences, variance risk premium, jump risk, stochastic volatility

JEL Classification: G12

Suggested Citation

Branger, Nicole and Rodrigues, Paulo and Schlag, Christian, The Role of Volatility Shocks and Rare Events in Long-Run Risk Models (March 11, 2011). Available at SSRN: https://ssrn.com/abstract=1785244 or http://dx.doi.org/10.2139/ssrn.1785244

Nicole Branger

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 29779 (Phone)
+49 251 83 22867 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=162

Paulo Rodrigues

Maastricht University - Department of Finance ( email )

Maastricht, 6200 MD
Netherlands

Christian Schlag (Contact Author)

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany
+49 69 798 33699 (Phone)

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