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An exploration of the effects of pessimism and doubt on asset returns

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  • Andrew B. Abel

Abstract

The subjective distribution of growth rates of aggregate consumption is characterized by pessimism if it is first-order stochastically dominated by the objective distribution. Uniform pessimism is a leftward translation of the objective distribution of the logarithm of the growth rate. The subjective distribution is characterized by doubt if it is mean-preserving spread of the objective distribution. Pessimism and doubt both reduce the riskfree rate and thus can help resolve the riskfree rate puzzle. Uniform pessimism and doubt both increase the average equity premium and thus can help resolve the equity premium puzzle.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 01-1.

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Date of creation: 2001
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Handle: RePEc:fip:fedpwp:01-1

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Keywords: Asset pricing ; Rational expectations (Economic theory);

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  1. Shmuel Kandel & Robert F. Stambaugh, 1991. "Asset Returns and Intertemporal Preferences," NBER Working Papers 3633, National Bureau of Economic Research, Inc.
  2. Lars Hansen & Thomas Sargent & Thomas Tallarini, . "Robust Permanent Income and Pricing," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 1997-51, Carnegie Mellon University, Tepper School of Business.
  3. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(1), pages 133-136, July.
  4. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  5. Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Mark, 1988. "Mean Reversion in Equilibrium Asset Prices," NBER Working Papers 2762, National Bureau of Economic Research, Inc.
  6. Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Mark, 1998. "Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good To Be True?," NBER Working Papers 6354, National Bureau of Economic Research, Inc.
  7. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(1), pages 117-131, July.
  8. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  9. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, Econometric Society, vol. 46(6), pages 1429-45, November.
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