The Market Price of Risk and the Equity Premium
Friedman and Schwartz hypothesized that the Great Depression created ex- aggerated fears of economic instability. We quantify their idea by using a robustness calculation to shatter a representative consumer’s initial confidence in the parameters of a two-state Markov chain that truly governs consump- tion growth. The assumption that the consumption data come from the true Markov chain and the consumer’s use of Bayes’ law cause that initial pessimism to wear off. But so long as it persists, the representative consumer’s pessimism contributes a volatile multiplicative component to the stochastic discount factor that would be measured by a rational expectation econometrician. We study how this component affects asset prices. We find settings of our parameters that make pessimism wear off slowly enough to allow our model to generate substantial values for the market price of risk and the equity premium.
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