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Continuous trading in an exchange economy under discontinuous dynamics: A resolution of the equity premium puzzle

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  • Aase, Knut K.

Abstract

This paper analyses asset prices, the term structure of the interest rate, the spot price of risk and derives the equilibrium excess returns on risky assets in an exchange economy where the underlying exogenous uncertainty is a pure multidimensional jump process. We derive closed-form solutions for the interest rate and the risk premiums on risky assets, as well as prices of derivative assets for a general class of separable utility indices and endowment processes. Our analysis demonstrates that when the underlying jumps of the aggregate consumption process are not negligible, then the traditional form of the consumption-based capital asset pricing model need not hold and the asset risk premiums may be larger than predicted by the traditional CCAPM in continuous time, based on Itô-diffusion processes. Our alternative model for the equity premiums lends itself to possible empirical testing. We also demonstrate that a more traditional consumption-based capital asset pricing type model approximately results when the jump sizes in the aggregate consumption are small. Our analysis suggests an explanation for the large estimates of the risk premiums reported in empirical tests of the single beta CCAPM. The analytical tool used is stochastic calculus for random point processes represented by random measures.

Suggested Citation

  • Aase, Knut K., 1993. "Continuous trading in an exchange economy under discontinuous dynamics: A resolution of the equity premium puzzle," Scandinavian Journal of Management, Elsevier, vol. 9(Supplemen), pages 3-28.
  • Handle: RePEc:eee:scaman:v:9:y:1993:i:supplement1:p:s3-s28
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    Cited by:

    1. Aase, Knut K., 2014. "Recursive utility and jump-diffusions," Discussion Papers 2014/9, Norwegian School of Economics, Department of Business and Management Science.
    2. Aase, Knut K., 2004. "Jump Dynamics: The Equity Premium and the Risk-Free Rate Puzzles," Discussion Papers 2004/12, Norwegian School of Economics, Department of Business and Management Science.
    3. Aase, Knut K., 2015. "The equity premium in a production economy; A new perspective involving recursive utility," Discussion Papers 2015/15, Norwegian School of Economics, Department of Business and Management Science.
    4. Jose S. Penalva Zuasti, 2001. "Insurance with Frequency Trading: A Dynamic Analysis of Efficient Insurance Markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(4), pages 790-822, October.
    5. Aase, Knut K. & Lillestøl, Jostein, 2015. "Beyond the local mean-variance analysis in continuous time: The problem of non-normality," Discussion Papers 2015/11, Norwegian School of Economics, Department of Business and Management Science.
    6. Aase, Knut K., 2000. "An equilibrium asset pricing model based on Lévy processes: relations to stochastic volatility, and the survival hypothesis," Insurance: Mathematics and Economics, Elsevier, vol. 27(3), pages 345-363, December.

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