A Business Cycle Asset Pricing Model
74 Pages Posted: 1 Nov 2019
Date Written: October 11, 2019
An asset pricing model is introduced that captures the market, liquidity, credit, and business cycle risks. The explicit incorporation of economic-phase-switching business cycle risks makes the predicted return volatility equal to the observed return volatility. Therefore, the concerns over excessive volatility and equity premium puzzle become insignificant in the model. The risk-return tradeoff dynamic disequilibrium model builds on the equilibrium CAPM, taken as its steady state. It has no worse explanatory power than that of the Fama-French three-factor model and its variants but significantly better out-of-sample predictive power and ex post S&P 500 portfolio returns over the last 20-year period.
Keywords: Asset Pricing Model, Economic-Phase-Switching Business Cycle
JEL Classification: G11 and G12
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