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Business Cycles and Regime-Shift Risk

58 Pages Posted: 26 Jan 2012  

Wei Yang

Indiana University - Kelley School of Business - Department of Finance

Date Written: December 1, 2011


The consumption growth data strongly favor a two-regime specification. The high volatility, low growth regime is associated with deep recessions: the Great Depression, the recession of 1937-1938, the post-war recession of 1945, and the most recent financial crisis. I develop parsimonious models in which (i) consumption and dividend growth follow regime-switching dynamics, (ii) the regime characteristics are consistent with the empirical evidence from the consumption growth data, and (iii) the risks associated with regime shifts are priced in asset markets. The models explain major regime-dependent asset market phenomena. Regime-shift risk exhibits the dominant influence on asset prices: It generates a high equity premium, and also induces time-varying risk premiums and explains the return predictability.

Keywords: Regime shifts, business cycles, equity premium, return predictability

JEL Classification: G12, E21

Suggested Citation

Yang, Wei, Business Cycles and Regime-Shift Risk (December 1, 2011). Available at SSRN: or

Wei Yang (Contact Author)

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

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