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Revisiting Equity Premium Puzzles in a Data-Rich Environment

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  • Mohamed Douch
  • Mohammed Bouaddi

Abstract

This paper modifies the conventional representative-agent consumption-based equilibrium models by making the habit-formation part depend on additional factors related to economic conditions. This paper assumes that innovations in the consumption surplus ratio are determined not only by consumption growth but also by other macroeconomic and financial factors. The resulting model allowed for a separation between the intertemporal elasticity of substitution and risk aversion. The model also generates highly volatile Intertemporal marginal rate of substitution which translates into fluctuating volatility capturing time varying economic uncertainty. The long-standing equity premium puzzle seems to have been resolved. The resulting pricing model accounts for a number of interesting properties, such as time-varying risk aversion, small relative risk aversion and an equity premium that is compatible with the observed equity premium. These results are obtained with admissible range of local relative risk aversion. In addition, the model generated small risk-free rate resolving the interest rate puzzle.

Suggested Citation

  • Mohamed Douch & Mohammed Bouaddi, 2019. "Revisiting Equity Premium Puzzles in a Data-Rich Environment," Applied Economics Quarterly (formerly: Konjunkturpolitik), Duncker & Humblot GmbH, Berlin, vol. 65(4), pages 257-275.
    • Handle: RePEc:dah:aeqaeq:v65_y2019_i4_q4_p257-275
    DOI: 10.3790/aeq.65.4.257
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    More about this item

    Keywords

    Common factors; factor analysis; principal components; asset pricing; equity premium puzzle; risk-free rate puzzle;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models

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