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State Dependent Preferences Can Explain the Equity Premium Puzzle

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  • Angelo Melino
  • Alan X. Yang

Abstract

We introduce state dependent recursive preferences into the Mehra-Prescott economy. We show that such preferences can match the historical first two moments of the returns on equity and the risk free rate. Other authors have reported similar results using state dependent expected utility preferences. These authors have tended to emphasize the importance of countercyclical risk aversion in explaining the equity premium puzzle. We find that countercyclical risk aversion plays an important role but only when combined with modest cyclical variation in intertemporal substitution.

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Bibliographic Info

Paper provided by University of Toronto, Department of Economics in its series Working Papers with number melino-03-01.

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Length: 34 pages
Date of creation: 11 Jul 2003
Date of revision:
Handle: RePEc:tor:tecipa:melino-03-01

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  1. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  2. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April.
  3. John H. Cochrane, 1997. "Where is the market going? Uncertain facts and novel theories," Economic Perspectives, Federal Reserve Bank of Chicago, issue Nov, pages 3-37.
  4. Sydney Ludvigson & Martin Lettau, 1999. "Consumption, aggregate wealth and expected stock returns," Staff Reports 77, Federal Reserve Bank of New York.
  5. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  6. S.G. Cecchetti & P. Lam & N.C. Mark, 2010. "The equity premium and the risk-free rate: matching the moments," Levine's Working Paper Archive 1396, David K. Levine.
  7. L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive 1400, David K. Levine.
  8. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  9. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
  10. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
  11. Pascal St-Amour & Stephen Gordon, 2000. "A Preference Regime Model of Bull and Bear Markets," American Economic Review, American Economic Association, vol. 90(4), pages 1019-1033, September.
  12. Gordon S. & St-Amour P., 2004. "Asset Returns and State-Dependent Risk Preferences," Journal of Business & Economic Statistics, American Statistical Association, vol. 22, pages 241-252, July.
  13. Larry G. Epstein & Stanley E. Zin, 1991. "The Independence Axiom and Asset Returns," NBER Technical Working Papers 0109, National Bureau of Economic Research, Inc.
  14. Larry G. Epstein & Angelo Melino, 1993. "A Revealed Preference Analysis of Asset Pricing Under Recursive Utility," NBER Working Papers 4524, National Bureau of Economic Research, Inc.
  15. Hansen, Lars Peter & Richard, Scott F, 1987. "The Role of Conditioning Information in Deducing Testable," Econometrica, Econometric Society, vol. 55(3), pages 587-613, May.
  16. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers 95-05, University of Iowa, Department of Economics.
  17. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  18. Epstein, Larry G., 1988. "Risk aversion and asset prices," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 179-192, September.
  19. John Y. Campbell, 1996. "Consumption and the Stock Market: Interpreting International Experience," NBER Working Papers 5610, National Bureau of Economic Research, Inc.
  20. Robert J. Shiller & John Y. Campbell, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Cowles Foundation Discussion Papers 812, Cowles Foundation for Research in Economics, Yale University.
  21. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  22. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  23. Kubler, Felix, 2004. "Is intertemporal choice theory testable?," Journal of Mathematical Economics, Elsevier, vol. 40(1-2), pages 177-189, February.
  24. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-86, April.
  25. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
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  1. Welfare costs of the business cycle and the equity premium
    by Stephen in Worthwhile Canadian Initiative on 2006-12-15 19:09:36
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