WHY ARE ASSET RETURNS MORE VOLATILE DURING RECESSIONS? A THEORETICAL EXPLANATION

During recession, many macroeconomic variables display higher levels of volatility. We show how introducing an AR(1)-ARCH(1) driving pro- cess into the canonical Lucas consumption CAPM framework can account for the empirically observed greater volatilty of asset returns during re- cessions. In particular, agents' joint forecasting of levels and time-varying second moments transforms symmetric-volatility driving processes into asymmetric-volatility endogenous variables. Moreover, numerical exam- ples show that the model can indeed account for the degree of cyclical variation in both bond and equity returns in the U.S. data. Finally, we argue that the underlying mechanism is not speci.c to .nancial markets, and has the potential to explain cyclical variation in the volatilities of a wide variety of macroeconomic variables.