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THE EQUITY PREMIUM PUZZLE AND THE RISK-FREE RATE PUZZLE

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Abstract

This paper studies the implications for general equilibnum asset pricing of a class of Kreps-Porteus nonexpected utility preferences characterized by a constant intertemporal elasticity of substitution and a constant, but unrelated, coefficient of relative risk aversion. It is shown that relaxing the parametric restriction on tastes imposed by the time-additive expected utility specification does not suffice to solve the Mehra-Prescott (1985) equity premium puzzle. An additional puzzle- the risk-free rate puzzle- emerges instead: why is the risk-free rate so low if agents are so averse to intertemporal substitution? 1.

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What this paper is about

This paper studies the implications for general equilibnum asset pricing of a class of Kreps-Porteus nonexpected utility preferences characterized by a constant intertemporal elasticity of substitution and a constant, but unrelated, coefficient of relative risk aversion. It is shown that relaxing the parametric restriction on tastes imposed by the time-additive expected utility specification does not suffice to solve the Mehra-Prescott (1985) equity premium puzzle. An additional puzzle- the risk-free rate puzzle- emerges instead: why is the risk-free rate so low if agents are so averse to intertemporal substitution? 1.

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Available abstract

This paper studies the implications for general equilibnum asset pricing of a class of Kreps-Porteus nonexpected utility preferences characterized by a constant intertemporal elasticity of substitution and a constant, but unrelated, coefficient of relative risk aversion. It is shown that relaxing the parametric restriction on tastes imposed by the time-additive expected utility specification does not suffice to solve the Mehra-Prescott (1985) equity premium puzzle. An additional puzzle- the risk-free rate puzzle- emerges instead: why is the risk-free rate so low if agents are so averse to intertemporal substitution? 1.

Key concepts: Equity premium puzzle, Economics, Elasticity of intertemporal substitution, Risk premium, Capital asset pricing model, Elasticity of substitution, Econometrics, Substitution (logic)

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