The equity premium and the risk-free rate: matching the moments
AbstractThis paper investigates the ability of a representative agent model with time separable utility to explain the mean vector and the covariance matrix of the risk free interest rate and the return to leveraged equity in the stock market. The paper generalizes the standard calibration methodology by accounting for the uncertainty in both the sample moments to be explained and the estimated parameters to which the model is calibrated. We develop a testing framework to evaluate the model's ability to match the moments of the data. We study two forms of the model, both of which treat leverage in a manner consistent with the data. In the first, dividends explicitly represent the flow that accrues to the owner of the equity, and they are discounted by the marginal rate of intertemporal substitution defined over consumption. The second form of the model introduces bonds and treats equities as the residual claim to the total endowment stream. We find that the first moments of the data can be matched for a wide range of preference parameter values. But for both models the implied first and second moments taken together are always statistically significantly different from the data at standard levels. This last result contrasts sharply with other recent treatments of leverage in the literature.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by David K. Levine in its series Levine's Working Paper Archive with number 1396.
Date of creation: 09 Dec 2010
Date of revision:
Contact details of provider:
Web page: http://www.dklevine.com/
Other versions of this item:
- Cecchetti, Stephen G. & Lam, Pok-sang & Mark, Nelson C., 1993. "The equity premium and the risk-free rate : Matching the moments," Journal of Monetary Economics, Elsevier, vol. 31(1), pages 21-45, February.
- Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Clark, 1991. "The Equity Premium and the Risk Free Rate: Matching the Moments," NBER Working Papers 3752, National Bureau of Economic Research, Inc.
- NEP-ALL-2010-12-18 (All new papers)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1990.
"Mean Reversion in Equilibrium Asset Prices,"
American Economic Review,
American Economic Association, vol. 80(3), pages 398-418, June.
- Mankiw, N. Gregory, 1986.
"The equity premium and the concentration of aggregate shocks,"
Journal of Financial Economics,
Elsevier, vol. 17(1), pages 211-219, September.
- N. Gregory Mankiw, 1987. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
- Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
- Whitney K. Newey & Kenneth D. West, 1986.
"A Simple, Positive Semi-Definite, Heteroskedasticity and AutocorrelationConsistent Covariance Matrix,"
NBER Technical Working Papers
0055, National Bureau of Economic Research, Inc.
- Newey, Whitney K & West, Kenneth D, 1987. "A Simple, Positive Semi-definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix," Econometrica, Econometric Society, vol. 55(3), pages 703-08, May.
- James M. Nason, 1988. "The equity premium and time-varying risk behavior," Finance and Economics Discussion Series 11, Board of Governors of the Federal Reserve System (U.S.).
- Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
- Lee, Bong-Soo & Ingram, Beth Fisher, 1991. "Simulation estimation of time-series models," Journal of Econometrics, Elsevier, vol. 47(2-3), pages 197-205, February.
- Andrew B. Abel, 1991. "The equity premium puzzle," Business Review, Federal Reserve Bank of Philadelphia, issue Sep, pages 3-14.
- Mehra, Rajnish & Prescott, Edward C., 1985.
"The equity premium: A puzzle,"
Journal of Monetary Economics,
Elsevier, vol. 15(2), pages 145-161, March.
- Sanford J. Grossman & Robert J. Shiller, 1982.
"Consumption Correlatedness and Risk Measurement in Economies with Non trade Assets and Heterogeneous Information,"
NBER Working Papers
0690, National Bureau of Economic Research, Inc.
- Grossman, Sanford J. & Shiller, Robert J., 1982. "Consumption correlatedness and risk measurement in economies with non-traded assets and heterogeneous information," Journal of Financial Economics, Elsevier, vol. 10(2), pages 195-210, July.
- John Y. Campbell & Robert J. Shiller, 1988.
"Cointegration and Tests of Present Value Models,"
NBER Working Papers
1885, National Bureau of Economic Research, Inc.
- Campbell, John & Shiller, Robert, 1987. "Cointegration and Tests of Present Value Models," Scholarly Articles 3122490, Harvard University Department of Economics.
- John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," Cowles Foundation Discussion Papers 785, Cowles Foundation for Research in Economics, Yale University.
- Pamela A. Labadie, 1988. "The effects of stochastic inflation on asset prices," Discussion Paper / Institute for Empirical Macroeconomics 5, Federal Reserve Bank of Minneapolis.
- Kydland, Finn E & Prescott, Edward C, 1982.
"Time to Build and Aggregate Fluctuations,"
Econometric Society, vol. 50(6), pages 1345-70, November.
- Finn E. Kydland & Edward C. Prescott, 1982. "Web interface for "Time to Build and Aggregate Fluctuations"," QM&RBC Codes 4a, Quantitative Macroeconomics & Real Business Cycles.
- Finn E. Kydland & Edward C. Prescott, 1982. "Executable program for "Time to Build and Aggregate Fluctuations"," QM&RBC Codes 4, Quantitative Macroeconomics & Real Business Cycles.
- Epstein, Larry G. & Zin, Stanley E., 1990.
"'First-order' risk aversion and the equity premium puzzle,"
Journal of Monetary Economics,
Elsevier, vol. 26(3), pages 387-407, December.
- L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive 1400, David K. Levine.
- Allan W. Gregory & Gregor W. Smith, 1988. "Calibration as Testing, Type I Error in the Equity Premium Puzzle," Working Papers 725, Queen's University, Department of Economics.
- Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
This item has more than 25 citations. To prevent cluttering this page, these citations are listed on a separate page. reading list or among the top items on IDEAS.Access and download statisticsgeneral information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (David K. Levine).
If references are entirely missing, you can add them using this form.