Regime shifts in a long-run risks model of stock and treasury bond markets

Abstract

PurposeThis paper aims to study the asset pricing implications for stock and bond markets in a long-run risks (LRR) model with regime shifts. This general equilibrium framework can not only generate sign-switching stock-bond correlations and bond risk premium, but also quantitatively reproduce various other salient empirical features in stock and bond markets, including time-varying equity and bond return premia, regime shifts in real and nominal yield curves, the violation of the expectations hypothesis of bond returns.Design/methodology/approachThe researchers study the joint determinants of stock and bond returns in a LRR model framework with regime shifts in consumption and inflation dynamics. In particular, the means, volatilities, and the correlation structure between consumption growth and inflation are regime-dependent.FindingsThe model shows that the term structure of interest rates and stock-bond correlation are intimately related to business cycles, while LRR play a more important role in accounting for high equity premium than do business cycle risks.Originality/valueThis paper studies the joint determinants of stock and bond returns in a Bansal and Yaron (2004) type of LRR framework. This rational expectations general equilibrium framework can (1) jointly match the dynamics of consumption, inflation and cash flow; (2) generate time-varying and sign-switching stock and bond correlations, as well as generating sign-switching bond risk premium; and (3) coherently explain another long list of salient empirical features in stock and bond markets, including time-varying equity and bond return premia, regime shifts in real and nominal yield curves, the violation of the expectations hypothesis of bond returns.