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Some solutions to the equity premium and volatility puzzles


  • Li, Jinlu


In this paper, I adopt an economic equilibrium model utilizing the framework introduced by Mehra and Prescott (1985) when they presented the equity premium puzzle. This model, in the long run and with respect to stationary probabilities, produces results that match the sample values derived from the U.S. economy between 1889 and 1978 as illustrated by the studies performed by Grossman and Shiller (1981), which includes the expected average, standard deviation, and first-order serial correlation of the growth rate of per capita real consumption and the expected returns and standard deviation of equity, risk-free security, and risk premium for equity. Therefore, this model solves the equity premium and volatility puzzles. I also explore the reasons why the equity premium puzzle was caused.

Suggested Citation

  • Li, Jinlu, 2010. "Some solutions to the equity premium and volatility puzzles," MPRA Paper 26833, University Library of Munich, Germany, revised 01 Aug 2010.
  • Handle: RePEc:pra:mprapa:26833

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    References listed on IDEAS

    1. Otrok, Christopher & Ravikumar, B. & Whiteman, Charles H., 2002. "Habit formation: a resolution of the equity premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1261-1288, September.
    2. Palomino, Frederic, 1996. " Noise Trading in Small Markets," Journal of Finance, American Finance Association, vol. 51(4), pages 1537-1550, September.
    3. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 73-92.
    4. Mankiw, N. Gregory, 1986. "The equity premium and the concentration of aggregate shocks," Journal of Financial Economics, Elsevier, vol. 17(1), pages 211-219, September.
    5. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
    6. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
    7. Simon Grant & John Quiggin, 2002. "The Risk Premium for Equity: Implications for the Proposed Diversification of the Social Security Fund," American Economic Review, American Economic Association, vol. 92(4), pages 1104-1115, September.
    8. Fatih Guvenen, 2009. "A Parsimonious Macroeconomic Model for Asset Pricing," Econometrica, Econometric Society, vol. 77(6), pages 1711-1750, November.
    9. Pok-sang Lam & Stephen G. Cecchetti & Nelson C. Mark, 2000. "Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?," American Economic Review, American Economic Association, vol. 90(4), pages 787-805, September.
    10. Uri Gneezy & Arie Kapteyn & Jan Potters, 2003. "Evaluation Periods and Asset Prices in a Market Experiment," Journal of Finance, American Finance Association, vol. 58(2), pages 821-838, April.
    11. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
    12. Merton, Robert C, 1987. " A Simple Model of Capital Market Equilibrium with Incomplete Information," Journal of Finance, American Finance Association, vol. 42(3), pages 483-510, July.
    13. 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.
    14. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
    15. Arrow, Kenneth J & Lind, Robert C, 1970. "Uncertainty and the Evaluation of Public Investment Decisions," American Economic Review, American Economic Association, vol. 60(3), pages 364-378, June.
    16. Shleifer, Andrei & Vishny, Robert W, 1990. "Equilibrium Short Horizons of Investors and Firms," American Economic Review, American Economic Association, vol. 80(2), pages 148-153, May.
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    More about this item


    The constant relative risk aversion class utility function; risk premium; time discount factor; parameters defining preferences; parameters defining technologies; the equity premium and volatility puzzles.;

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • E01 - Macroeconomics and Monetary Economics - - General - - - Measurement and Data on National Income and Product Accounts and Wealth; Environmental Accounts

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