Regime Shifts in a Long-run Risks Model of U.S. Stock and Treasury Bond Markets

Abstract

I study the joint determinants of stock and bond returns in Bansal and Yaron (2004) long-run risks model framework with regime shifts in consumption and in‡ation dynamics –in particular, the means, volatilities, and the correlation structure between consumption growth and in‡ation are regime-dependent. This general equilibrium framework can (1) generate time-varying and switching signs of stock and bond correlations, as well as switching signs of bond risk premium; (2) 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 curve, the violation of expectations hypothesis of bond returns. The model shows that term structure of interest rates and stock-bond correlation are intimately related to business cycles, while long-run risks play a more important role to account for high equity premium than business cycle risks.