The equity premium puzzle and the risk-free rate puzzle

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?

What Fisher knew about his relation, we sometimes forget

“…First, we find that the long run inflation coefficient is not significantly different than one, as expected. Second, the time preference rate is insignificantly different than zero, which is consistent with the risk-free bond rate puzzle identified by Weil (1989). Third, the findings support our theory that consumption 2 The proper inflation measure is the 'inverse of the expected rate of decrease in purchasing power due to inflation' rather than the 'rate of inflation' itself.…”

Do self-control preferences help explain the puzzling behavior of asset prices?

“…First, stock prices are highly volatile relative to corresponding discounted dividend streams (LeRoy and Porter, 1981; Shiller, 1981; Grossman and Shiller, 1981). Also, average returns to holdings of relatively riskless assets (e.g., government bonds) are very low, while in turn, the average return premium generated by equity holdings over bond holdings is quite high (Mehra and Prescott, 1985;Weil, 1989). Despite the large literatures that have emerged in response to the original statements of these puzzles, de…nitive…”

Managing Climate Change Under Uncertainty: Recursive Integrated Assessment at an Inflection Point

“…Using common calibrations of recursive utility strongly reduces optimal emissions. Recursive utility, often implemented as Epstein-Zin-Weil (Epstein and Zin, 1989;Weil, 1989) preferences, separates risk aversion from the elasticity of intertemporal substitution, whereas the standard expected utility representation forces one to be the reciprocal of the other. Common calibrations set the elasticity of intertemporal substitution at a value strictly greater than 1 and set relative risk aversion to an even greater value.…”