The Journal of Finance publishes leading research across all the major fields of finance. It is one of the most widely cited journals in academic finance, and in all of economics. Each of the six issues per year reaches over 8,000 academics, finance professionals, libraries, and government and financial institutions around the world. The journal is the official publication of The American Finance Association, the premier academic organization devoted to the study and promotion of knowledge about financial economics.
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Can Time‐Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?
Published: 01/30/2013 | DOI: 10.1111/jofi.12018
JESSICA A. WACHTER
Why is the equity premium so high, and why are stocks so volatile? Why are stock returns in excess of government bill rates predictable? This paper proposes an answer to these questions based on a time‐varying probability of a consumption disaster. In the model, aggregate consumption follows a normal distribution with low volatility most of the time, but with some probability of a consumption realization far out in the left tail. The possibility of this poor outcome substantially increases the equity premium, while time‐variation in the probability of this outcome drives high stock market volatility and excess return predictability.
Discussion
Published: 12/17/2002 | DOI: 10.1111/0022-1082.00370
Jessica A. Wachter
Does the Failure of the Expectations Hypothesis Matter for Long‐Term Investors?
Published: 07/20/2005 | DOI: 10.1111/j.1540-6261.2005.00728.x
ANTONIOS SANGVINATSOS, JESSICA A. WACHTER
We solve the portfolio problem of a long‐run investor when the term structure is Gaussian and when the investor has access to nominal bonds and stock. We apply our method to a three‐factor model that captures the failure of the expectations hypothesis. We extend this model to account for time‐varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio of a long‐run investor looks very different from the portfolio of a mean‐variance optimizer. In particular, time‐varying term premia generate large hedging demands for long‐term bonds.
Why Is Long‐Horizon Equity Less Risky? A Duration‐Based Explanation of the Value Premium
Published: 01/11/2007 | DOI: 10.1111/j.1540-6261.2007.01201.x
MARTIN LETTAU, JESSICA A. WACHTER
We propose a dynamic risk‐based model that captures the value premium. Firms are modeled as long‐lived assets distinguished by the timing of cash flows. The stochastic discount factor is specified so that shocks to aggregate dividends are priced, but shocks to the discount rate are not. The model implies that growth firms covary more with the discount rate than do value firms, which covary more with cash flows. When calibrated to explain aggregate stock market behavior, the model accounts for the observed value premium, the high Sharpe ratios on value firms, and the poor performance of the CAPM.
Do Rare Events Explain CDX Tranche Spreads?
Published: 08/09/2018 | DOI: 10.1111/jofi.12705
SANG BYUNG SEO, JESSICA A. WACHTER
We investigate whether a model with time‐varying probability of economic disaster can explain prices of collateralized debt obligations. We focus on senior tranches of the CDX, an index of credit default swaps on investment grade firms. These assets do not incur losses until a large fraction of previously stable firms default, and thus are deep out‐of‐the money put options on the overall economy. When calibrated to consumption data and to the equity premium, the model explains the spreads on CDX tranches prior to and during the 2008 to 2009 crisis.