Real(istic) Time-Varying Probability of Consumption Disasters
64 Pages Posted: 30 Apr 2021 Last revised: 18 May 2021
Date Written: March 31, 2021
We model the time-varying probability of consumption disasters with international risk interactions and estimate the model using national accounts data of 42 countries back to 1833. The estimated world and country-specific disaster probabilities accord well with historical macroeconomic disasters. A match of equity premium requires a relative risk aversion coefficient around 5, substantively smaller than the previous estimates. Also, the model delivers a significantly better match for the equity volatility than alternative rare disaster models. Finally, the disaster probability index estimated from the model can predict equity returns in the very long term---up to 50 years.
Keywords: consumption disasters, time-varying probability, asset pricing, risk aversion, equity-premium prediction
JEL Classification: G12, E21, E44
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