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State Dependent Preferences Can Explain the Equity Premium Puzzle

  • Angelo Melino
  • Alan X. Yang

We introduce state dependent recursive preferences into the Mehra-Prescott economy. We show that such preferences can match the historical first two moments of the returns on equity and the risk free rate. Other authors have reported similar results using state dependent expected utility preferences. These authors have tended to emphasize the importance of countercyclical risk aversion in explaining the equity premium puzzle. We find that countercyclical risk aversion plays an important role but only when combined with modest cyclical variation in intertemporal substitution.

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Paper provided by University of Toronto, Department of Economics in its series Working Papers with number melino-03-01.

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Length: 34 pages
Date of creation: 11 Jul 2003
Date of revision:
Handle: RePEc:tor:tecipa:melino-03-01
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  1. Larry G. Epstein & Angelo Melino, 1995. "A Revealed Preference Analysis of Asset Pricing Under Recursive Utility," Review of Economic Studies, Oxford University Press, vol. 62(4), pages 597-618.
  2. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  3. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  4. Narayana R. Kocherlakota, 1996. "The Equity Premium: It's Still a Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(1), pages 42-71, March.
  5. 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.
  6. John H Cochrane, 2003. "Where is the Market Going: Uncertain Facts and Novel Theories," Levine's Working Paper Archive 618897000000000762, David K. Levine.
  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 Gordon & Pascal St-Amour, 2003. "Asset Returns and State-Dependent Risk Preferences," CIRANO Working Papers 2003s-09, CIRANO.
  10. 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.
  11. Gordon, Stephen & St-Amour, Pascal, 1999. "A Preference Regime Model of Bull and Bear Markets," Cahiers de recherche 9906, Université Laval - Département d'économique.
  12. Epstein, Larry G. & Zin, Stanley E., 2001. "The independence axiom and asset returns," Journal of Empirical Finance, Elsevier, vol. 8(5), pages 537-572, December.
  13. Lettau, Martin & Ludvigson, Sydney, 1999. "Consumption, Aggregate Wealth and Expected Stock Returns," CEPR Discussion Papers 2223, C.E.P.R. Discussion Papers.
  14. John Y. Campbell, 1996. "Consumption and the Stock Market: Interpreting International Experience," NBER Working Papers 5610, National Bureau of Economic Research, Inc.
  15. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  16. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
  17. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-86, April.
  18. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
  19. Hansen, Lars Peter & Richard, Scott F, 1987. "The Role of Conditioning Information in Deducing Testable," Econometrica, Econometric Society, vol. 55(3), pages 587-613, May.
  20. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  21. Epstein, Larry G., 1988. "Risk aversion and asset prices," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 179-192, September.
  22. 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.
  23. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
  24. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  25. Kubler, Felix, 2004. "Is intertemporal choice theory testable?," Journal of Mathematical Economics, Elsevier, vol. 40(1-2), pages 177-189, February.
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