Real(istic) Time-Varying Probability of Consumption Disasters

Xiaoyu Huang, Tao Jin, and Hao Zhou

♦ 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, significantly lower than previous estimates. Furthermore, the model provides notably better fits for equity volatility compared to alternative rare disaster models. Finally, the disaster probability index estimated from the model demonstrates significant out-of-sample predictive power over long horizons, performing well not only over time but also across countries.

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