EQUITY-PREMIUM AND RISK-FREE-RATE PUZZLES AT  LONG HORIZONS

In this paper, we study the risk averse investor's equilibrium equity premium in a semi martingale market with arbitrary jumps. We realize that, if we normalize the market, the equilibrium equity premium is consistent to taking the risk free rate $\rho=0$ in martingale markets. We also observe that the value process affects both the diffusive and rare-event premia except for the CARA negative exponential utility function. The bond price always affect the diffusive risk premium for this risk averse investor.

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A Re-examination of the Equity Premium Puzzle and the Risk-Free Rate Puzzle in Korea

Asian Review of Financial Research ◽

10.37197/arfr.2020.33.1.4 ◽

2020 ◽

Vol 33 (1) ◽

pp. 97-144

Author(s):

Min-Jik Kim ◽

◽

Jaeho Cho

Keyword(s):

Equity Premium ◽

Equity Premium Puzzle ◽

Premium Puzzle ◽

Risk Free Rate ◽

Free Rate

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Ambiguity Aversion and the Variance Premium

Quarterly Journal of Finance ◽

10.1142/s2010139219500034 ◽

2019 ◽

Vol 09 (02) ◽

pp. 1950003 ◽

Cited By ~ 4

Author(s):

Jianjun Miao ◽

Bin Wei ◽

Hao Zhou

Keyword(s):

Risk Aversion ◽

Ambiguity Aversion ◽

Equity Premium ◽

Return Variance ◽

Quantitative Performance ◽

The Mean ◽

The Difference ◽

Risk Free Rate ◽

Mean Variance ◽

Free Rate

This paper offers an ambiguity-based interpretation of the variance premium — the difference between risk-neutral and objective expectations of market return variance — as a compounding effect of both belief distortion and variance differential regarding the uncertain economic regimes. Our calibrated model can match the variance premium, the equity premium, and the risk-free rate in the data. We find that about 97% of the mean–variance premium can be attributed to ambiguity aversion. A three-way separation among ambiguity aversion, risk aversion, and intertemporal substitution, permitted by the smooth ambiguity preferences, plays a key role in our model’s quantitative performance.

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Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?

The American Economic Review ◽

10.1257/aer.90.4.787 ◽

2000 ◽

Vol 90 (4) ◽

pp. 787-805 ◽

Cited By ~ 216

Author(s):

Stephen G Cecchetti ◽

Pok-Sang Lam ◽

Nelson C Mark

Keyword(s):

Asset Pricing ◽

Equity Premium ◽

Equity Returns ◽

Relative Risk Aversion ◽

Pricing Model ◽

Asset Pricing Model ◽

Subjective Beliefs ◽

Second Moments ◽

Risk Free Rate ◽

Free Rate

We study a Lucas asset-pricing model that is standard in all respects, except that the representative agent's subjective beliefs about endowment growth are distorted. Using constant relative risk-aversion (CRRA) utility, with a CRRA coefficient below 10; fluctuating beliefs that exhibit, on average, excessive pessimism over expansions; and excessive optimism over contractions (both ending more quickly than the data suggest), our model is able to match the first and second moments of the equity premium and risk-free rate, as well as the persistence and predictability of excess returns found in the data. (JEL E44, G12)

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ELUCIDATING EQUITY PREMIUM USING CORPORATE DIVIDENDS AND HABIT FORMATION

Annals of Financial Economics ◽

10.1142/s2010495215500141 ◽

2015 ◽

Vol 10 (02) ◽

pp. 1550014

Author(s):

JOW-RAN CHANG ◽

HSU-HSIEN CHU

Keyword(s):

Habit Formation ◽

Diffusion Processes ◽

Equity Premium ◽

Closed Form Solutions ◽

Consumption Ratio ◽

Jump Diffusion Processes ◽

Risk Free Rate ◽

Stock Values ◽

Special Case ◽

Free Rate

This paper extends Longstaff and Piazzesi (2004, Journal of Financial Economics, 74, 401–421.) to a habit formation model. By combining corporate fraction ratio, and surplus consumption ratio, we derive closed-form solutions for stock values when dividends, habit ratio and consumption follow exponential affine jump-diffusion processes. We can prove that Longstaff and Piazzesi (2004) is only a special case of our model. In addition, calibrated results show that the corporate fraction and habit ratio to shocks significantly increases the equity premium and decreases the risk-free rate. The model determines realistic values for the equity premium and the risk-free rate.

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