Abstract
We introduce a market, liquidity, credit, and business-cycle risks asset pricing model. Because of the phase-switching business-cycle risks and price-setting monopolistic competition, it has rational expectations and predictability. The unconditional-predicted and observed return volatilities are equal. However, their conditional returns are different. They mitigate the excessive volatility and equity premium puzzle. The risk-return tradeoff dynamic disequilibrium model builds on the equilibrium CAPM, taken as its steady state. Using the last 30-year S&P 500 data, reversal, and momentum investment strategies, it has competitive in-sample explanatory and superior out-of-sample predictive power, above the CAPM, Fama-French three-factor model, and its variants.
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