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A New Solution to the Equity Premium Puzzle and the Risk-Free Rate Puzzle: Theory and Evidence

Author

Listed:
  • Hideaki Tamura

    (Graduate School of Economics, Kobe University)

  • Yoichi Matsubayashi

    (Graduate School of Economics, Kobe University)

Abstract

This paper develops a new method for solving both equity premium and risk free rate puzzles based on the standard utility function. The method for solving the equity premium puzzle in accordance with Mehra and Prescott (1985) needs to be simultaneously consistent with the method for solving the risk-free rate puzzle presented by Weil (1989). That is, the reasonable estimated values for the degree of relative risk aversion in the former solution and for the subjective discount rate in the latter solution need to plausibly fall within experiential bounds. This study indicates that a consistent solution is possible for the equity premium and risk-free rate puzzles even when there is a standard constant relative risk aversion (CRRA) type utility function. This solution is possible by formularizing the Euler equation for consumption, considering the precautionary saving effect.

Suggested Citation

  • Hideaki Tamura & Yoichi Matsubayashi, 2014. "A New Solution to the Equity Premium Puzzle and the Risk-Free Rate Puzzle: Theory and Evidence," Discussion Papers 1422, Graduate School of Economics, Kobe University.
    • Handle: RePEc:koe:wpaper:1422
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    File URL: http://www.econ.kobe-u.ac.jp/RePEc/koe/wpaper/2014/1422.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    equity premium puzzle; risk-free rate puzzle; uncertainty; Euler equation;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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