Real(istic) Time-Varying Probability of Consumption Disasters

Abstract 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 the equity premium requires a relative risk aversion coefficient of approximately 5, which is significantly lower than previous estimates. Furthermore, the model provides notably better fits for equity volatility compared with 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.