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Substitution, risk aversion, taste shocks and equity premia

Author

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  • Michel Normandin

    (Département des Sciences Economiques and Centre de Recherche sur l'Emploi et les Fluctuations Economiques, Université du Québec, Montréal, C.P. 8888, Succ. Centre Ville, Montréal, Québec, Canada, H3C 3P8)

  • Pascal St-Amour

    (Département d'Économique and Centre de Recherche en Économie et Finances Appliquées, Université Laval, Cité Universitaire, Québec, Canada, G1K 7P4)

Abstract

This paper gauges the relative contribution of risk aversion, inter-temporal substitution and taste shocks on postwar monthly US equity premia. The time-varying consumption, market, and taste risks involved in the Euler equations are recovered from a common factor GARCH process and the MLE are obtained by applying the Kalman filter. Empirically, (1) the market risk is the only source of risk that does not statistically affect the equity premia, and thus, the hypothesis that the coefficient of relative risk aversion corresponds to the reciprocal of the elasticity of inter-temporal substitution is not rejected; (2) the estimates are reasonable, so that the equity premium puzzle is circumvented; and (3) taste risks are quantitatively important in capturing excess returns movements. © 1998 John Wiley & Sons, Ltd.

Suggested Citation

  • Michel Normandin & Pascal St-Amour, 1998. "Substitution, risk aversion, taste shocks and equity premia," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 13(3), pages 265-281.
  • Handle: RePEc:jae:japmet:v:13:y:1998:i:3:p:265-281
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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