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Information and the Equity Premium

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We consider the effect of information on the average risk-free rate and the average equity premium in a standard two-period exchange economy with complete markets and a representative agent. We show that information always increases the average risk-free rate. Clearly, perfect information eliminates the equity premium; moreover, we show that a particular kind of information about the level of the return to equity always decreases the average equity premium. Surprisingly, however, information must sometimes raise the premium, no matter what the preferences of the representative agent; and information purely about the volatility of the return always raises the equity premium for a interesting class of preferences. We use these results to illuminate the equity premium and risk-free rate puzzles.

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Paper provided by Department of Economics, W. P. Carey School of Business, Arizona State University in its series Working Papers with number 2133505.

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Handle: RePEc:asu:wpaper:2133505

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