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State Dependent Preferences Can Explain the Equity Premium Puzzle

  • Angelo Melino

    (University of Toronto)

  • Alan X. Yang

    (Algorithmics Inc.)

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. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/S1094-2025(03)00046-2
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Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 6 (2003)
Issue (Month): 4 (October)
Pages: 806-830

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Handle: RePEc:red:issued:v:6:y:2003:i:4:p:806-830
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  1. 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.
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  3. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers 95-05, University of Iowa, Department of Economics.
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  8. John H. Cochrane, 1998. "Where is the Market Going? Uncertain Facts and Novel Theories," NBER Working Papers 6207, National Bureau of Economic Research, Inc.
  9. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
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  19. Epstein, Larry G. & Zin, Stanley E., 2001. "The independence axiom and asset returns," Journal of Empirical Finance, Elsevier, vol. 8(5), pages 537-572, December.
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