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State Dependent Preferences Can Explain the Equity Premium Puzzle

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  • Angelo Melino

    (University of Toronto)

  • Alan X. Yang

    (Algorithmics Inc.)

Abstract

We introduce state dependent recursive preferences into the Mehra-Prescott economy. We show that such preferences can match the historical first two moments of the returns on equity and the risk free rate. Other authors have reported similar results using state dependent expected utility preferences. These authors have tended to emphasize the importance of countercyclical risk aversion in explaining the equity premium puzzle. We find that countercyclical risk aversion plays an important role but only when combined with modest cyclical variation in intertemporal substitution. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/S1094-2025(03)00046-2
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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 6 (2003)
Issue (Month): 4 (October)
Pages: 806-830

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Handle: RePEc:red:issued:v:6:y:2003:i:4:p:806-830

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  1. Larry G. Epstein & Angelo Melino, 1993. "A Revealed Preference Analysis of Asset Pricing Under Recursive Utility," NBER Working Papers 4524, National Bureau of Economic Research, Inc.
  2. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  3. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  4. Martin Lettau, 2001. "Consumption, Aggregate Wealth, and Expected Stock Returns," Journal of Finance, American Finance Association, vol. 56(3), pages 815-849, 06.
  5. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  6. John Y. Campbell, 1996. "Consumption and the Stock Market: Interpreting International Experience," Harvard Institute of Economic Research Working Papers 1763, Harvard - Institute of Economic Research.
  7. John H. Cochrane, 1998. "Where is the Market Going? Uncertain Facts and Novel Theories," NBER Working Papers 6207, National Bureau of Economic Research, Inc.
  8. Stephen Gordon & Pascal St-Amour, 2003. "Asset Returns and State-Dependent Risk Preferences," CIRANO Working Papers 2003s-09, CIRANO.
  9. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers 95-05, University of Iowa, Department of Economics.
  10. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
  11. Larry G. Epstein & Stanley E. Zin, 1991. "The Independence Axiom and Asset Returns," NBER Technical Working Papers 0109, National Bureau of Economic Research, Inc.
  12. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
  13. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of Security Market Data for Models of Dynamic Economies," NBER Technical Working Papers 0089, National Bureau of Economic Research, Inc.
  14. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-86, April.
  15. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
  16. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  17. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  18. Kubler, Felix, 2004. "Is intertemporal choice theory testable?," Journal of Mathematical Economics, Elsevier, vol. 40(1-2), pages 177-189, February.
  19. Hansen, Lars Peter & Richard, Scott F, 1987. "The Role of Conditioning Information in Deducing Testable," Econometrica, Econometric Society, vol. 55(3), pages 587-613, May.
  20. L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive 1400, David K. Levine.
  21. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  22. Gordon, Stephen & St-Amour, Pascal, 1999. "A Preference Regime Model of Bull and Bear Markets," Cahiers de recherche 9906, Université Laval - Département d'économique.
  23. S.G. Cecchetti & P. Lam & N.C. Mark, 2010. "The equity premium and the risk-free rate: matching the moments," Levine's Working Paper Archive 1396, David K. Levine.
  24. John Y. Campbell & Robert J. Shiller, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," NBER Working Papers 2100, National Bureau of Economic Research, Inc.
  25. Epstein, Larry G., 1988. "Risk aversion and asset prices," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 179-192, September.
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  1. Welfare costs of the business cycle and the equity premium
    by Stephen in Worthwhile Canadian Initiative on 2006-12-15 19:09:36
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