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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. 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.
  2. 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.
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  7. Bonomo, M. & Garcia, R., 1991. "Consumption and Equilibrium Asset Pricing: an Empirical Assessment," Cahiers de recherche 9126, Universite de Montreal, Departement de sciences economiques.
  8. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  9. Myung Jig Kim & Charles R. Nelson & Richard Startz, 1988. "Mean Reversion in Stock Prices? A Reappraisal of the Empirical Evidence," NBER Working Papers 2795, National Bureau of Economic Research, Inc.
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  13. 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.
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  17. René Garcia, 1995. "Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models," CIRANO Working Papers 95s-07, CIRANO.
  18. 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.
  19. 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.
  20. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
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  25. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  26. 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.
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