Working Paper: CEPR ID: DP10520
Authors: Francesco Bianchi
Abstract: Similarities between the Great Depression and the Great Recession are documented with respect to the behavior of financial markets. A Great Depression regime is identified by using a Markov-switching VAR. The probability of this regime has remained close to zero for many decades, but spiked for a short period during the most recent financial crisis, the Great Recession. The Great Depression regime implies a collapse of the stock market, with small-growth stocks outperforming small-value stocks. This helps to explain the cross section of asset returns when risk is priced according to a version of the "Bad Beta, Good Beta" Intertemporal CAPM that allows for regime changes.
Keywords: Financial Crises; Great Depression; Great Recession; Intertemporal CAPM; Markov-Switching VAR
JEL Codes: C32; G01; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Great Depression regime (E65) | significant stock market collapse (G10) |
| Great Depression regime (E65) | small growth stocks outperform small value stocks (L25) |
| Great Recession (G01) | probability of entering Great Depression regime spikes (E32) |
| probability of entering Great Depression regime spikes (E32) | dramatic decline in stock market (G10) |
| innovations to market returns (G11) | value spread (D46) |
| rare events (G14) | affect realized returns (G17) |
| rare events (G14) | shape agents' expectations regarding future risks and returns (D84) |