Working Paper: NBER ID: w14386
Authors: 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.
Keywords: equity premium; stock market volatility; time-varying disaster risk
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| probability of a consumption disaster (D12) | equity premium (G12) |
| probability of a consumption disaster (D12) | stock market volatility (G17) |
| probability of a consumption disaster (D12) | excess return predictability (G17) |
| equity premium (G12) | stock market volatility (G17) |
| increased disaster risk (H84) | lower risk-free rates (G19) |