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Is There a Structural Break in the Equity Premium

In this paper, we apply a Bayesian approach to test for a structural break with unknown breakpoint in an empirical model of excess returns that allows the equity premium to change in response to recurrent changes in the level of volatility. The main questions we seek to answer with our approach are the following: Is there evidence of changes in the equity premium over time? If so, can these changes be explained as the consequence of recurrent changes in the level of volatility? Or, alternatively, does the equity premium undergo a one-time permanent structural break? For monthly excess returns on a value-weighted portfolio of NYSE stocks between 1926-1991, we  ̄nd strong evidence for a structural break in the Markov-switching variance process around 1941. However, the data provide little evidence of a concurrent structural break in the equity premium. Instead, the data suggest that changes in the equity premium are mainly a consequence of recurrent changes in the level of volatility.