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Why Are Asset Returns more Volatile During Recessions? A Theoretical Examination

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  • Monique C. Ebell

    (Universitat Pompeu Fabra)

Abstract

During recessions, many macroeconomic variables display higher levels of volatility. We show how introducing an AR(1)-ARCH(1) driving process into the canonical Lucas consumption CAPM framework can account for the empirically observed greater volatility of asset returns during recessions. In particular, agents' joint forecasting of levels and time-varying second moments transforms symmetric-volatility forcing processes into asymmetric- volatility endogenous variables. Moreover, numerical examples show that the model can indeed account for the degree of cyclical variation in both bond and equity return volatilities in the U.S. data. Finally, we argue that the underlying mechanism is not specific to financial markets, and has the potential to account for the greater volatility during recessions of a wide variety of macroeconomic variables.

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Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1554.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:1554

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  1. Breeden, Douglas T & Gibbons, Michael R & Litzenberger, Robert H, 1989. " Empirical Tests of the Consumption-Oriented CAPM," Journal of Finance, American Finance Association, American Finance Association, vol. 44(2), pages 231-62, June.
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  16. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, Econometric Society, vol. 46(6), pages 1429-45, November.
  17. Kandel, Shmuel & Stambaugh, Robert F, 1990. "Expectations and Volatility of Consumption and Asset Returns," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 3(2), pages 207-32.
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