Exact Solutions for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium Puzzle
This paper derives simple closed-form solutions for expected rates of return on stocks and riskless one-period bills under the assumption that shocks to the growth rates of consumption and dividends are generated by a Markov regime-switching process. These closed-form solutions are used to show that the Markov regime-switching process exacerbates the equity premium puzzle and the risk-free rate puzzle. Three empirical examples illustrate the magnitude of the effects of Markov regime switching on equilibrium expected returns.
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- Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
- Cecchetti, Stephen G. & Lam, Pok-sang & Mark, Nelson C., 1993.
"The equity premium and the risk-free rate : Matching the moments,"
Journal of Monetary Economics,
Elsevier, vol. 31(1), pages 21-45, February.
- Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Clark, 1991. "The Equity Premium and the Risk Free Rate: Matching the Moments," NBER Working Papers 3752, National Bureau of Economic Research, Inc.
- S.G. Cecchetti & P. Lam & N.C. Mark, 2010. "The equity premium and the risk-free rate: matching the moments," Levine's Working Paper Archive 1396, David K. Levine.
- Weil, Philippe, 1989.
"The equity premium puzzle and the risk-free rate puzzle,"
Journal of Monetary Economics,
Elsevier, vol. 24(3), pages 401-421, November.
- Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
- Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
- Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1990. "Mean Reversion in Equilibrium Asset Prices," American Economic Review, American Economic Association, vol. 80(3), pages 398-418, June.
- Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-384, March.
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