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Why are Asset Returns More Volatile during Recessions? A Theoretical Explanation

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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-varing second moments transforms symmetric-volatility driving 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 returns in the U.S. data. Finally, we argue that the underlying mechanism is not specific to financial markets, and has the potential to explain cyclical variation in the volatilities of a wide variety of macroeconomic variables.

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  • Monique Ebell, 2001. "Why are Asset Returns More Volatile during Recessions? A Theoretical Explanation," Working Papers 01.01, Swiss National Bank, Study Center Gerzensee.
  • Handle: RePEc:szg:worpap:0101
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    Cited by:

    1. Zeng, Songlin & Bec, Frédérique, 2015. "Do stock returns rebound after bear markets? An empirical analysis from five OECD countries," Journal of Empirical Finance, Elsevier, vol. 30(C), pages 50-61.
    2. Frédérique Bec & Annabelle de Gaye, 2019. "Le modèle autorégressif autorégressif à seuil avec effet rebond : Une application aux rendements boursiers français et américains ," Working Papers hal-02014663, HAL.
    3. Duncan, Roberto, 2016. "Does the US current account show a symmetric behavior over the business cycle?," International Review of Economics & Finance, Elsevier, vol. 41(C), pages 202-219.
    4. Hess, Martin K., 2003. "What drives Markov regime-switching behavior of stock markets? The Swiss case," International Review of Financial Analysis, Elsevier, vol. 12(5), pages 527-543.
    5. Van Nieuwerburgh, Stijn & Veldkamp, Laura, 2006. "Learning asymmetries in real business cycles," Journal of Monetary Economics, Elsevier, vol. 53(4), pages 753-772, May.
    6. Martin Hess, 2006. "Timing and diversification: A state-dependent asset allocation approach," The European Journal of Finance, Taylor & Francis Journals, vol. 12(3), pages 189-204.

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