A Business Cycle Capital Asset Pricing Model
72 Pages Posted: 25 Jan 2021 Last revised: 22 Mar 2021
Date Written: December 23, 2020
We introduce a market, liquidity, credit, and business-cycle risks asset pricing model. Because of the phase-switching business-cycle risks and price-setting monopolistic competition, it has rational expectations and predictability. The unconditional-predicted and observed return volatilities are equal. However, their conditional returns are different. They mitigate the excessive volatility and equity premium puzzle. The risk-return tradeoff dynamic disequilibrium model builds on the equilibrium CAPM, taken as its steady state. Using the last 30-year S&P 500 data, reversal, and momentum investment strategies, it has competitive in-sample explanatory and superior out-of-sample predictive power, above the CAPM, Fama-French three-factor model, and its variants.
Keywords: Business-Cycle CAPM, Rational Expectations, Predictability, Real Interest Rates, Idiosyncratic Volatility, Equity Premium Puzzles, Monopolistic Competition
JEL Classification: G11, G12
Suggested Citation: Suggested Citation