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The Equity Premium is No Puzzle


  • Mordecai Kurz
  • Andrea Beltratti


February 12, 1996 (First draft: May 17, 1995) We examine the equity premium puzzle with the perspective of the theory of Rational Beliefs Equilibrium (RBE) and show that from the perspective of this theory there is no puzzle. In an RBE agents need to be compensated for the endogenously propagated price uncertainty which is not permitted under rational expectations. It is then argued that endogenous uncertainty is the predominant uncertainty of asset returns and its presence provides a natural explanation of the observed premium. Utilizing data on the asset allocation of 63 U.S. mutual funds, we test some empirical implications of the theory of rational beliefs as well as estimate the parameters of risk aversion of mutual fund managers. Our tests show that the predictions of the theory are consistent with the empirical evidence. We then construct a simple two agent model of the U.S. economy in which the agents hold rational beliefs and calibrate it to the empirical experience in accord with the parameters of the Mehra and Prescott (1985) paper. The results of our calculations show that the model predictions fit closely the historical record.

Suggested Citation

  • Mordecai Kurz & Andrea Beltratti, "undated". "The Equity Premium is No Puzzle," Working Papers 96004, Stanford University, Department of Economics.
  • Handle: RePEc:wop:stanec:96004

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    References listed on IDEAS

    1. Simon Wren-Lewis & Rebecca Driver, 1998. "Real Exchange Rates for the Year 2000," Peterson Institute Press: Policy Analyses in International Economics, Peterson Institute for International Economics, number pa54, October.
    2. Thomas F. Cargill & Michael M. Hutchison & Takatoshi Ito, 1997. "The Political Economy of Japanese Monetary Policy," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262032473, July.
    3. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
    4. Kathryn Dominguez & Jeffrey A. Frankel, 1990. "Does Foreign Exchange Intervention Work?," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 16.
    5. Adam S. Posen, 1998. "Restoring Japan's Economic Growth," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 35.
    6. Ronald I. McKinnon, 1996. "The Rules of the Game: International Money and Exchange Rates," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262133180, July.
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    Cited by:

    1. Ellen R. McGrattan & Edward C. Prescott, 2001. "Taxes, Regulations, and Asset Prices," NBER Working Papers 8623, National Bureau of Economic Research, Inc.
    2. Ellen R. McGrattan & Edward C. Prescott, 2000. "Is the stock market overvalued?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40.
    3. Gregorio Impavido & Esperanza Lasagabaster & Manuel Garcia-Huitron, 2010. "New Policies for Mandatory Defined Contribution Pensions : Industrial Organization Models and Investment Products," World Bank Publications, The World Bank, number 2462, September.
    4. repec:idb:idbbks:365 is not listed on IDEAS
    5. Christophe Faugere & Julian Van Erlach, 2003. "The Equity Premium: Explained by GDP Growth and Consistent with Portfolio Insurance," Finance 0311004, EconWPA.

    More about this item

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates


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