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Risk Based Explanations of the Equity Premium

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  • John Donaldson
  • Rajnish Mehra

Abstract

This essay reviews the family of models that seek to provide aggregate risk based explanations for the empirically observed equity premium. Theories based on non-expected utility preference structures, limited financial market participation, model uncertainty and the small probability of enormous losses are detailed. We impose the additional requirements that candidate models yield consistent inter temporal portfolio choice and that a representative agent can be constructed which is independent of the underlying heterogeneous economy's initial wealth distribution. While many models are able to replicate a wide variety of financial statistics including the premium, few satisfy these latter criteria as well.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13220.

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Date of creation: Jul 2007
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Publication status: published as “Risk Based Explanations of the Equity Premium” (with J.B Donaldson) Handbook of Investments: The Handbook of the Equity Risk Premium. ed. by Rajnish Mehra, Elsevier, Amsterdam, 2008, pp 37- 100.
Handle: RePEc:nbr:nberwo:13220

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Cited by:
  1. Azeredo, Francisco, 2007. "The Equity Premium: A Deeper Puzzle," University of California at Santa Barbara, Economics Working Paper Series qt6ks5p6v5, Department of Economics, UC Santa Barbara.
  2. Yongli Zhang, 2010. "Fluctuations of Real Interest Rates and Business Cycles," Annals of Economics and Finance, Society for AEF, vol. 11(1), pages 185-208, May.

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