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The Equity Premium Puzzle: Pitfalls in Estimating the Coefficient of Relative Risk Aversion

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  • Michael Donadelli
  • Lorenzo Prosperi

Abstract

Standard consumption-based models typically fail in pricing asset returns. In a famous seminal paper, Mehra and Prescott (1985), using a standard consumption model, prove the presence of a puzzle (i.e. equity premium puzzle). The recent financial literature still has to provide a convincing resolution to the well known puzzle. In contrast to this literature, which mainly focuses on the United States data, our paper simply replicates the closed form solution estimation, as in Mehra (2003), for a bunch of developed and emerging markets. On one side, our estimations confirm the existence of the puzzle and lead to bizarre values of the coefficient of relative risk aversion. On the other side, we claim that the key consumption model assumptions, the choice of a proper riskless asset and the lack of data, generate obstacles in finding robustness in the estimations of the CRRA coefficients, both in developed and emerging markets.

Suggested Citation

  • Michael Donadelli & Lorenzo Prosperi, 2012. "The Equity Premium Puzzle: Pitfalls in Estimating the Coefficient of Relative Risk Aversion," Journal of Applied Finance & Banking, SCIENPRESS Ltd, vol. 2(2), pages 1-7.
    • Handle: RePEc:spt:apfiba:v:2:y:2012:i:2:f:2_2_7
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    Cited by:

    1. Rishma Vedd & Paul Lazarony, 2014. "The Risk-Return Trade-Off Of Investing In Latin American Emerging Stock Markets," Accounting & Taxation, The Institute for Business and Finance Research, vol. 6(1), pages 93-104.
    2. Curatola, Giuliano & Donadelli, Michael & Grüning, Patrick, 2015. "Matching the BRIC equity premium: A structural approach," Emerging Markets Review, Elsevier, vol. 22(C), pages 65-75.
    3. Othieno, Ferdinand & Biekpe, Nicholas, 2019. "Estimating the conditional equity risk premium in African frontier markets," Research in International Business and Finance, Elsevier, vol. 47(C), pages 538-551.
    4. Michael Donadelli & Marcella Lucchetta, 2013. "Emerging Stock Premia: Some Evidence From Industrial Stock Market Data," Asian Economic and Financial Review, Asian Economic and Social Society, vol. 3(4), pages 398-422, April.

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