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Institutional Volatility and the Equity Premium Puzzle: A Dynamic Asset Pricing Framework for OECD Economies

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  • Heng-fu Zou

Abstract

This paper develops a novel institution-based asset pricing model to address the longstanding equity premium puzzle within the context of OECD economies. We endogenize institutional quality -- capturing property rights, rule of law, and political stability -- as a capital-like state variable subject to stochastic shocks, depreciation, and investment. Building on recursive utility and production-based frameworks, we derive the stochastic discount factor (SDF) and demonstrate how institutional volatility amplifes consumption risk and increases equity premia. Our analytical results and numerical simulations show that economies with stronger and more stable institutions exhibit lower risk premia and smoother asset returns, while institutional uncertainty generates excess volatility and persistent return differentials. Empirical proxies -- including political risk indices, rule-of-law scores, and policy uncertainty measures -- confirm the model's predictions across OECD stock markets. This approach not only helps resolve the equity premium puzzle but also highlights the macro financial significance of investing in and protecting institutional capital.

Suggested Citation

  • Heng-fu Zou, 2025. "Institutional Volatility and the Equity Premium Puzzle: A Dynamic Asset Pricing Framework for OECD Economies," CEMA Working Papers 775, China Economics and Management Academy, Central University of Finance and Economics.
  • Handle: RePEc:cuf:wpaper:775
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    Cited by:

    1. Wei Liang & Heng-fu Zou, 2025. "Liberal Ideas Capital and Asset Pricing: A Political Economy of Risk, Return, and Freedom," CEMA Working Papers 779, China Economics and Management Academy, Central University of Finance and Economics.
    2. Heng-fu Zou, 2025. "Institutional Disaster Risk and Asset Pricing: A Unified Framework Integrating Rare Events and Endogenous Political Shocks," CEMA Working Papers 777, China Economics and Management Academy, Central University of Finance and Economics.
    3. Heng-fu Zou, 2025. "Institutions and Asset Returns," CEMA Working Papers 778, China Economics and Management Academy, Central University of Finance and Economics.

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