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

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 norma...

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Bibliographic Details
Published in:The Journal of finance (New York) 2013-06, Vol.68 (3), p.987-1035
Main Author: WACHTER, JESSICA A.
Format: Article
Language:English
Subjects:
Bills
Calibration
Consumption
Consumption theory
Disasters
Dividends
Economic models
Equity
Financial risk
Modeling
Normal distribution
Predictability
Probability theory
Rates of return
Risk aversion
Risk exposure
Securities analysis
Securities markets
Simulations
Stock exchange
Stock markets
Studies
Volatility
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Summary: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.
ISSN:0022-1082
1540-6261
DOI:10.1111/jofi.12018