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

Jessica A. Wachter ()

No 14386, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper introduces a model in which the probability of a rare disaster varies over time. I show that the model can account for the high equity premium and high volatility in the aggregate stock market. At the same time, the model generates a low mean and volatility for the government bill rate, as well as economically significant excess stock return predictability. The model is set in continuous time, assumes recursive preferences and is solved in closed-form. It is shown that recursive preferences, as well as time-variation in the disaster probability, are key to the model's success.

JEL-codes: G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-fmk, nep-rmg and nep-upt
Date: 2008-10
Note: AP EFG
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