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Jump Dynamics: The Equity Premium and the Risk-Free Rate Puzzles

  • Aase, Knut K.

    ()

    (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

The paper develops a consumption based equilibrium model, focusing on the risk premium and the risk-free interest rate. We derive testable expressions for these quantities, and confront these with sample estimates for the 20. century. Our framework is a dynamic model in continuous time, allowing for random jumps at random time points, in addition to diffusion uncertainty. Preferences are time separable and additive. The classical equity premium puzzle and the risk-free rate puzzle are re-examined. We present values for the parameters of the representative agent's utility function for different values of risk premia and interest rates, calibrated to two first moments of the US-data of the last century. Relatively low values for agents' risk aversion are consistent with the model, but positive values of the subjective interest rate seem harder to fit.

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File URL: http://hdl.handle.net/11250/164036
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Paper provided by Department of Business and Management Science, Norwegian School of Economics in its series Discussion Papers with number 2004/12.

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Length: 28 pages
Date of creation: 21 Oct 2004
Date of revision:
Handle: RePEc:hhs:nhhfms:2004_012
Contact details of provider: Postal: NHH, Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway
Phone: +47 55 95 92 93
Fax: +47 55 95 96 50
Web page: http://www.nhh.no/en/research-faculty/department-of-business-and-management-science.aspx
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  1. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics 29, Federal Reserve Bank of Minneapolis.
  2. Tobin, James, 1969. "Comment on Borch and Feldstein," Review of Economic Studies, Wiley Blackwell, vol. 36(105), pages 13-14, January.
  3. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
  4. Sundaresan, Suresh M, 1989. "Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth," Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 73-89.
  5. Ellen R. McGrattan & Edward C. Prescott, 2003. "Average debt and equity returns: puzzling?," Staff Report 313, Federal Reserve Bank of Minneapolis.
  6. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  7. Knut K. Aase, 1993. "A Jump/Diffusion Consumption-Based Capital Asset Pricing Model and the Equity Premium Puzzle," Mathematical Finance, Wiley Blackwell, vol. 3(2), pages 65-84.
  8. Aase, Knut K., 1993. "Continuous trading in an exchange economy under discontinuous dynamics: A resolution of the equity premium puzzle," Scandinavian Journal of Management, Elsevier, vol. 9(Supplemen), pages S3-S28.
  9. Feldstein, Martin S, 1969. "Mean-Variance Analysis in the Theory of Liquidity Preference and Portfolio Selection," Review of Economic Studies, Wiley Blackwell, vol. 36(105), pages 5-12, January.
  10. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  11. Olivier Allais, 2004. "Local Substitution and Habit Persistence: Matching the Moments of the Equity Premium and the Risk-Free Rate," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(2), pages 265-296, April.
  12. Detemple, Jerome B & Zapatero, Fernando, 1991. "Asset Prices in an Exchange Economy with Habit Formation," Econometrica, Econometric Society, vol. 59(6), pages 1633-57, November.
  13. Borch, Karl, 1969. "A Note on Uncertainty and Indifference Curves," Review of Economic Studies, Wiley Blackwell, vol. 36(105), pages 1-4, January.
  14. Haug, Jorgen, 2001. "Explicit characterizations of financial prices with history-dependent utility," Journal of Mathematical Economics, Elsevier, vol. 36(4), pages 337-356, December.
  15. Knut K. Aase, 2002. "Equilibrium Pricing in the Presence of Cumulative Dividends Following a Diffusion," Mathematical Finance, Wiley Blackwell, vol. 12(3), pages 173-198.
  16. Sydney Ludvigson & Xiaohong Chen, 2004. "Land of Addicts? An Empirical Investigation of Habit-Based Asset Pricing Models," 2004 Meeting Papers 692, Society for Economic Dynamics.
  17. Aase, Knut K. & ├śksendal, Bernt, 1988. "Admissible investment strategies in continuous trading," Stochastic Processes and their Applications, Elsevier, vol. 30(2), pages 291-301, December.
  18. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  19. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  20. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  21. Back, Kerry, 1991. "Asset pricing for general processes," Journal of Mathematical Economics, Elsevier, vol. 20(4), pages 371-395.
  22. Salyer, Kevin D., 1998. "Crash states and the equity premium: Solving one puzzle raises another," Journal of Economic Dynamics and Control, Elsevier, vol. 22(6), pages 955-965, June.
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