Real(istic) Time-Varying Probability of Consumption Disasters

Abstract

We model the time-varying probability of consumption disasters with international risk interactions and estimate the model using national accounts data of 42 countries back to 1833. The estimated world and country-specific disaster probabilities accord well with historical macroeconomic disasters. A match of equity premium requires a relative risk aversion coefficient around 5, substantively smaller than the previous estimates. Also, the model delivers a significantly better match for the equity volatility than alternative rare disaster models. Finally, the disaster probability index estimated from the model can predict equity returns in the very long term---up to 50 years.