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

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  • Jessica Wachter

Abstract

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.

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  • Jessica Wachter, 2008. "Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?," NBER Working Papers 14386, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:14386
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    References listed on IDEAS

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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