Asset pricing with time varying pessimism and rare disasters

Abstract

We incorporate time-varying consumption volatility in the representative-agent asset pricing model with generalized recursive smooth ambiguity preferences developed by Ju and Miao (2012). We calibrate the model to data on consumption and asset returns since the Great Depression period. Uncertainty aversion amplifies the perceived probability of the disastrous state coupled with high consumption volatility. We find that the model with time-varying volatility generates a high equity risk premium. When we impose the condition that no consumption disasters ever realized in simulated samples, the model with time-varying volatility can reproduce predictability of returns and non-predictability of consumption growth simultaneously, which are consistent with empirical findings.