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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 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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Article provided by American Finance Association in its journal Journal of Finance.

Volume (Year): 68 (2013)
Issue (Month): 3 (06)
Pages: 987-1035

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Handle: RePEc:bla:jfinan:v:68:y:2013:i:3:p:987-1035
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  1. Naik, Vasanttilak & Lee, Moon, 1990. "General Equilibrium Pricing of Options on the Market Portfolio with Discontinuous Returns," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 493-521.
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  19. Fran├žois Gourio, 2008. "Time-series predictability in the disaster model," Boston University - Department of Economics - Working Papers Series wp2008-016, Boston University - Department of Economics.
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