Title: Term structure of recession probabilities and the cross section of asset returns
Authors: Ti Zhou - Southern University of Science and Technology (China) [presenting]
Abstract: The duration of business cycles changes over time, generating time-varying investor concern about recessions. We study a new macro-factor model that directly links assets' risk premia to such a concern, measured by the term structure of recession probabilities from professional forecasters. The innovation to the slope of the term structure is negatively priced with an economically large and significant risk premium in a wide range of tests assets, consistent with how the slope predicts long-run macroeconomic activity and labor income growth. A linear factor model, including market and the innovation to the slope, explains more than half of the cross-sectional variation of average excess returns on portfolios sorted on size, book-to-market, past long term return and asset growth. The factor mimicking portfolios of the model help reconcile the joint cross section of returns on equities, equity index options, and currencies and have pricing performance comparable to several multi-factor benchmarks. My evidence suggests that the slope of the term structure is a recession state variable, and an economic source of risk premia on test assets can be attributed to time-varying investor concern over future recessions that is priced.