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Risk Weighted Utility Theory as a Solution to the Equity Premium Puzzle

Author

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  • Thierry Chauveau

    (TEAM - Théories et Applications en Microéconomie et Macroéconomie - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, CDC - Caisse des Dépôts et Consignations)

  • Nicolas Nalpas

    (TEAM - Théories et Applications en Microéconomie et Macroéconomie - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique)

Abstract

In this paper, we formulate a restatement of the theory of choice under uncertainty. As an alternative to the rank-dependent expected utility model, we develop a probability-altering theory in which the transformation of probabilities is weighted by the centerred outcome of the lottery which may be viewed as "pure" risk. Using a weak restriction on the changes of probability measure, we avoid stochastic dominance inconsistency. We examine the main effects of this new approach on financial market equilibrium, especially in terms of Euler stochastic equations. Using such an approach allows for accounting for both high equity risk premia and low risk free rates without unrealistic assumptions upon the values of parameters characterizing the behavior of the representative consumer.

Suggested Citation

  • Thierry Chauveau & Nicolas Nalpas, 1999. "Risk Weighted Utility Theory as a Solution to the Equity Premium Puzzle," Post-Print halshs-03591443, HAL.
    • Handle: RePEc:hal:journl:halshs-03591443
    Note: View the original document on HAL open archive server: https://shs.hal.science/halshs-03591443
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    References listed on IDEAS

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    1. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
    2. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
    3. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    4. Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-587, May.
    5. Machina, Mark J., 1989. "Comparative statics and non-expected utility preferences," Journal of Economic Theory, Elsevier, vol. 47(2), pages 393-405, April.
    6. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    7. Machina, Mark J, 1982. ""Expected Utility" Analysis without the Independence Axiom," Econometrica, Econometric Society, vol. 50(2), pages 277-323, March.
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