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

Abstract

Purpose

This 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/approach

The 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.

Findings

The 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/value

This 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.

Citation

Li, K. and Xu, C. (2022), "Regime shifts in a long-run risks model of stock and treasury bond markets", China Finance Review International, Vol. 12 No. 4, pp. 541-570. https://doi.org/10.1108/CFRI-06-2022-0106