Economic events and the volatility of government bill rates.

Abstract

Many studies show that in many countries (especially the G7), volatility in government bill rates far exceeds that in consumption growth rates. This volatility puzzle cannot be predicted by traditional disaster models, in which rare economic disasters are defined as a peak-to-trough percent fall in consumption (or real per capita GDP) by a high threshold (≥10%). For this purpose, we extend the traditional definition of rare economic disasters and propose a novel asset pricing model that models both good and bad events. We define a bad (or good) event as a peak-to-trough absolute decline (or a trough-to-peak absolute rise) in consumption growth rates by a low threshold (<10%). Compared to traditional disaster models, our model contains three improvements. First, model good and bad events, not just bad ones (e.g., rare economic disasters). Second, the event's impact lasts for multiple periods rather than one period. Third, model non-rare economic events. We calibrate the parameters in our model to match the moments from U.S. asset return data. Simulation results indicate that the model can successfully predict the volatility of U.S. government bill rates higher than that of U.S. consumption growth rates.