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

  • Jessica Wachter

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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File URL: http://www.nber.org/papers/w14386.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14386.

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Date of creation: Oct 2008
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Publication status: published as Jessica A. Wachter, 2013. "Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?," Journal of Finance, American Finance Association, vol. 68(3), pages 987-1035, 06.
Handle: RePEc:nbr:nberwo:14386
Note: AP EFG
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