Asset Pricing with Regime-Dependent Preferences and Learning

Abstract

This paper studies equilibrium in a pure exchange economy with unobservable Markov switching consumption growth regimes and regime-dependent preferences. Variations in risk attitudes have fundamental effects on the structure of equilibrium. Explicit solutions are provided for the market price of risk, the interest rate, stock and bond prices, and asset return volatilities. Calibration shows that this one-factor model can simultaneously support empirical long run values of the market price of risk, the interest rate, the stock market volatility, the equity premium and the moments of the consumption growth rate. Dynamic properties of the model are examined. An implied recession index is constructed and its performance evaluated. The ability to explain the dividend strips puzzle, the term structure of interest rates and the predictive behavior of the term premium are studied.

Keywords: Asset pricing puzzles, regime-dependent preferences, incomplete information, equity premium, riskless rate, equity volatility, term structure, bond volatility, dividend strips, implied recession probability, recession detection