A Business Cycle Asset Pricing Model

Abstract

An asset pricing model is introduced that captures the market, liquidity, credit, and business cycle risks. The explicit incorporation of economic-phase-switching business cycle risks with rational expectations makes the predicted return volatility equal to the observed return volatility. Therefore, the concerns over excessive volatility and equity premium puzzle become insignificant. The risk-return tradeoff dynamic disequilibrium model builds on the equilibrium CAPM, taken as its steady state. It has no worse explanatory power than that of the Fama-French three-factor model and its variants but significantly better out-of-sample predictive power and ex-post S&P 500 portfolio returns over the last 20-year period.