Modeling Dynamic Term Structure of Equity Premia with Regime Switching Economy

Abstract

This paper proposes a consumption based asset pricing model in which the dynamic term structure of equity premia captures the stylized behavior of empirical counterpart. In the fi nancial crisis in late 2000s, the level of equity premium went up and especially the equity premium for a short horizon surged with a spike. To model these phenomena, I estimate two state regime switching model for the bivariate process of consumption and dividend over the period 1930-2011, and fi nd that the risk of regime switching can explain the level and slope of term structure of equity premia and the high volatility of short duration equity premium. In the economic downturn, accompanied with low growth and high volatility, the representative agent requires higher premium on equity, and since short duration assets are more exposed to the recession, those assets are heavily discounted. Consequently, the dynamics of term structure of equity premia show the following features: countercyclical level, procyclical slope, and high volatility of short term equity premium.