Contrary to well-known asset pricing models, volatilities implied by equity index options exceed realized stock market volatility and exhibit a pattern known as the volatility skew. We explain both facts using a model that can also account for the mean and volatility of equity returns. Our model assumes a small risk of economic disaster that is calibrated based on international data on large consumption declines. We allow the disaster probability to be stochastic, which turns out to be crucial to the model's ability both to match equity volatility and to reconcile option prices with macroeconomic data on disasters.
The equity premium, namely the expected return on the aggregate stock market less the government bill rate, is of central importance to the portfolio allocation of individuals, to the investment decisions of firms, and to model calibration and testing. This quantity is usually estimated from the sample average excess return. We propose an alternative esti- mator, based on maximum likelihood, that takes into account informa- tion contained in dividends and prices. Applied to the postwar sample, our method leads to an economically significant reduction from 6.4% to 5.1%. Simulation results show that our method produces more reliable estimates under a wide range of specifications.
What is the driving force behind the cyclical behavior of unemployment and vacancies? What is the relation between job-creation incentives of firms and stock market valuations? We answer these questions in a model with time-varying risk, modeled as a small and variable probability of an economic disaster. A high probability implies greater risk and lower future growth, lowering the incentives of firms to invest in hiring. During periods of high risk, stock market valuations are low and unemployment rises. The model thus explains volatility in equity and labor markets, and the relation between the two.