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The Equity Premium and the Business Cycle: the Role of Demand and Supply Shocks

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  • Smith, Peter N
  • Sorensen, Steffen
  • Wickens, Michael R.

Abstract

This paper explores the effects of the US business cycle on US stock market returns through an analysis of the equity risk premium. We propose a new methodology based on the SDF approach to asset pricing that allows us to uncover the different effects of aggregate demand and supply shocks. We find that negative shocks are more important that positive shocks, and that supply shocks have a much greater impact than demand shocks.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7227.

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Date of creation: Mar 2009
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Handle: RePEc:cpr:ceprdp:7227

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Keywords: business cycles; demand and supply shocks; equity premium; stock returns;

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References

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  1. G. William Schwert, 1998. "Stock Market Volatility: Ten Years After the Crash," NBER Working Papers 6381, National Bureau of Economic Research, Inc.
  2. Paul Harrison & Harold H. Zhang, 1999. "An Investigation Of The Risk And Return Relation At Long Horizons," The Review of Economics and Statistics, MIT Press, vol. 81(3), pages 399-408, August.
  3. Smith, Peter & Wickens, Michael, 2002. " Asset Pricing with Observable Stochastic Discount Factors," Journal of Economic Surveys, Wiley Blackwell, vol. 16(3), pages 397-446, July.
  4. Chauvet, Marcelle & Potter, Simon, 2001. "Nonlinear Risk," Macroeconomic Dynamics, Cambridge University Press, vol. 5(04), pages 621-646, September.
  5. G. William Schwert, 1990. "Why Does Stock Market Volatility Change Over Time?," NBER Working Papers 2798, National Bureau of Economic Research, Inc.
  6. Baillie, R.T. & Degennaro, R.P., 1988. "Stock Returns And Volatility," Papers 8803, Michigan State - Econometrics and Economic Theory.
  7. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
  8. Bekaert, Geert & Wu, Guojun, 2000. "Asymmetric Volatility and Risk in Equity Markets," Review of Financial Studies, Society for Financial Studies, vol. 13(1), pages 1-42.
  9. Scruggs, John T. & Glabadanidis, Paskalis, 2003. "Risk Premia and the Dynamic Covariance between Stock and Bond Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 38(02), pages 295-316, June.
  10. Harvey, Campbell R., 1989. "Time-varying conditional covariances in tests of asset pricing models," Journal of Financial Economics, Elsevier, vol. 24(2), pages 289-317.
  11. Keating, John W., 2000. "Macroeconomic Modeling with Asymmetric Vector Autoregressions," Journal of Macroeconomics, Elsevier, vol. 22(1), pages 1-28, January.
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Cited by:
  1. Alfonso Mendoza Velázquez & Peter N. Smith, 2012. "Equity Returns and the Business Cycle: The Role of Supply and Demand Shocks," Discussion Papers 12/36, Department of Economics, University of York.
  2. Kizys, Renatas & Pierdzioch, Christian, 2010. "The business cycle and the equity risk premium in real time," International Review of Economics & Finance, Elsevier, vol. 19(4), pages 711-722, October.

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