General equilibrium pricing with multiple dividend streams and regime switching

Jia Shen and Robert J. Elliott

Quantitative Finance, 2015, vol. 15, issue 9, 1543-1557

Abstract: In this paper, we investigate a regime switching Lucas economy in continuous time, with multiple dividend streams and labour income. We determine the asset prices in equilibrium in the economy with regime switching, and derive a system of partial differential equations for the asset prices and the short interest rate. The solutions for the endogenous short interest rate, the bond price and the yield of the bond are obtained. We also consider applications of the equilibrium model and show that the model implies a rich framework for the term structure of interest rates. We demonstrate how the regime switching economy helps to improve the model-implied annual excess rate of return. This assists in explaining the famous equity premium puzzle.

Date: 2015
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DOI: 10.1080/14697688.2014.974872

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