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Disappointment aversion as a solution to the equity premium and the risk-free rate puzzles

  • Marco Antonio Bonomo

    (Department of Economics PUC-Rio)

  • Rene Garcia

In this paper, we match both the first and the second moments of the equity premium and the risk-free rate by endowing the agents in the economy with disappointment aversion preferences and by making the joint process of consumption and dividends follow a Hamilton's (1989) Markov switching model. The interesting feature about the model proposed in this paper is that we need both disappointment aversion and a Markov switching endowment to match the first and second moments of both real and excess returns. With disappointment averse agents but a joint random walk for consumption and dividend growth rates, the average equity premium produced by the model is in the order of 2.5% compared with 5.3% in our sample. With isoelastic preferences but a bivariate three-state Markov switching model for consumption and dividend growth rates, the equity premium is 1.7% for a coefficient of relative risk aversion of 8 and a discount factor of 0.98, while the standard deviations for both the equity premium and the risk-free rate are close to the observed ones. The mean of the risk-free rate stands however very high at 13%. For a disappointment averse consumer, who weights more bad outcomes than good ones (where bad and good are defined with reference to a certainty equivalent measure of a gamble), it is precisely the existence of a bad state that lowers the equilibrium risk-free rate and increases the mean stock return, thereby producing the desired equity premium. Dans le présent article, nous reproduisons les premier et deuxième moments de la prime de risque sur les actions et du taux de risque en dotant les agents dans notre économie de préférences exhibant de l'averison pour la déception et en adoptant un modèle à changements de régime markoviens (Hamilton (1989)) pour le processus conjoint de la consommation et des dividendes. Le modèle proposé a la particularité intéressante de devoir combiner l'aversion pour la déception et une dotation à changements de régime markoviens pour

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Paper provided by Department of Economics PUC-Rio (Brazil) in its series Textos para discussão with number 308.

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Length: 33 pages
Date of creation: Sep 1993
Date of revision:
Handle: RePEc:rio:texdis:308
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  1. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc.
  2. Cecchetti, Stephen G & Mark, Nelson C, 1990. "Evaluating Empirical Tests of Asset Pricing Models: Alternative Interpretations," American Economic Review, American Economic Association, vol. 80(2), pages 48-51, May.
  3. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
  4. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, vol. 46(1), pages 185-200, January.
  5. Goetzman, W.N. & Jorion, P., 1992. "Testing the Predictive Power of Dividend Yields," Papers 93-03, Columbia - Graduate School of Business.
  6. Andrew B. Abel, . "Exact Solutions for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium Puzzle," Rodney L. White Center for Financial Research Working Papers 09-92, Wharton School Rodney L. White Center for Financial Research.
  7. Epstein, Larry G. & Zin, Stanley E., 1990. "'First-order' risk aversion and the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 387-407, December.
  8. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  9. 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.
  10. Shmuel Kandel & Robert F. Stambaugh, 1991. "Asset Returns and Intertemporal Preferences," NBER Working Papers 3633, National Bureau of Economic Research, Inc.
  11. Hansen, Bruce E, 1992. "The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages S61-82, Suppl. De.
  12. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April.
  13. Larry G. Epstein & Stanley E. Zin, 1991. "The Independence Axiom and Asset Returns," NBER Technical Working Papers 0109, National Bureau of Economic Research, Inc.
  14. 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.
  15. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  16. 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 357-84, March.
  17. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  18. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  19. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  20. Bonomo, Marco & Garcia, Rene, 1996. "Consumption and equilibrium asset pricing: An empirical assessment," Journal of Empirical Finance, Elsevier, vol. 3(3), pages 239-265, September.
  21. René Garcia, 1995. "Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models," CIRANO Working Papers 95s-07, CIRANO.
  22. Tauchen, George, 1986. "Statistical Properties of Generalized Method-of-Moments Estimators of Structural Parameters Obtained from Financial Market Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 4(4), pages 397-416, October.
  23. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  24. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of Security Market Data for Models of Dynamic Economies," NBER Technical Working Papers 0089, National Bureau of Economic Research, Inc.
  25. Uzi Segal & Avia Spivak, 1988. "First Order Versus Second Order Risk Aversion," UCLA Economics Working Papers 540, UCLA Department of Economics.
  26. Kim, Myung Jig & Nelson, Charles R & Startz, Richard, 1991. "Mean Reversion in Stock Prices? A Reappraisal of the Empirical Evidence," Review of Economic Studies, Wiley Blackwell, vol. 58(3), pages 515-28, May.
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