Douch, Mohamed and Bouaddi, Mohammed (2010): EQUITY Premium Puzzle in a Data-Rich Environment. Forthcoming in:
Download (1954Kb) | Preview
Standard consumption-based asset pricing models focus on the consumption risk, seen as the only source of fluctuations and information about risk for the informed investor. These models, however, can account for high expected excess stock return only when assuming implausible relative risk aversion. This paper adds additional risk factors to the standard C-CAPM model to resolve both the equity premium and the risk-free rate puzzles as well as the risk-free rate volatility puzzle. By adding other relevant risk factors, the resulting pricing model is able to explain these puzzles relying on admissible range of local relative risk aversion. The model generates, also, a time-varying relative risk aversion and intertemporal elasticity of substitution.
|Item Type:||MPRA Paper|
|Original Title:||EQUITY Premium Puzzle in a Data-Rich Environment|
|Keywords:||Common factors, factor analysis, principal components, asset pricing, equity premium puzzle, risk free rate puzzle.|
|Subjects:||G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates
G - Financial Economics > G1 - General Financial Markets > G10 - General
|Depositing User:||Mohamed Douch|
|Date Deposited:||11. Mar 2011 19:52|
|Last Modified:||16. Feb 2013 03:25|
Abel, A., (1990), ’Asset prices under habit formation and catching up with the Joneses’, American Economic Review,80, pp. 38–42.
Bekaert, G.,E. Engstrom and S. Grenadier, (2004), ’Stock and bond returns with moody investors’, Unpublished working paper, Columbia University, Stanford University, and University of Michigan.
Bai, J and S. Ng, (2002), ’Determining the Number of Factors in Approximate Factor Models’, Econometrica, 70,pp. 191–221.
———, (2008), ’Forecasting economic time series using targeted predictors’, Journal of Econometrics 146, pp. 304–317.
Barr, D. G., and J. Y. Campbell, (1997), ’Inzation, Real Interest Rates, and the Bond Market: A Study of UK Nominal and Index-Linked Government Bond Prices’ Journal of Monetary Economics, 39, pp. 361–383.
Becker, G., K. Murphy and I.Werning, (2005), ’The Equilibrium Distribution of Income and the Market for Status’,Journal of Political Economy, 113 (2), pp. 282-310.
Bernanke, B. S. and K. Kuttner, (2005), ’What Explains the Stock Market’s Reaction to Federal Reserve Policy?’,Journal of Finance, 60 (3), pp. 1221–1257.
Bjørnland, H. C. and K. Leitemo, (2009), ’Identifying the interdependence between US monetary policy and thestock market’, Journal of Monetary Economics, Elsevier, 56 (2), pp. 275-282.
Boivin, J., and M. Giannoni, (2005), ’DSGE Models in a Data-Rich Environment’, Unpublished Paper, Columbia University.
Boldrin, M., L. Christiano and J. Fisher, (2001), ’Habit persistence, asset returns, and the business cycle’, American Economic Review, 91, pp. 149–66.
Boyd, J. H., J. Hu and R. Jagannathan, (2005), ‘The Stock Market’s Reaction to Unemployment News: Why Bad News is Usually Good for Stocks’, Journal of Finance, 60 (2), pp. 649–672.
Buraschi, A. and A. Jiltsov, (2005), 'Inflation risk premia and the expectations hypothesis', Journal of Financial Economics, 75, pp. 429-490.
Caballero, R.J., (1990), 'Consumption puzzles and precautionary savings', Journal of Monetary Economics, 25, pp. 113-136.
Campbell, J. Y., and J. Cochrane, (1999), 'By Force of Habit: A Consumption-based Explanation of Aggregate Stock Market Behavior', Journal of Political Economy, 107, pp. 205-251.
Campbell, J.Y. and R.J. Shiller, (1996), 'A scorecard for indexed government debt', In: B.S. Bernanke, J. Rotemberg (Eds.), NBER Macroeconomics Annual, MIT Press, Cambridge, MA.
Chen, N., R. Roll and S. Ross, (1986), 'Economic Forces and the Stock Market', Journal of Business, 59 (3), pp. 383-403.
Chen, X., S.C. Ludvigson, (2003), 'Land of addicts? An empirical investigation of habit-based asset pricing models', Working paper, New York University.
Christiano, L. J., R. Motto, and M. Rostagno, (2008), 'Shocks, Structures or Monetary Policies? The Euro Area and the US After 2001', Journal of Economic Dynamics and Control, 32, pp. 2476-2506.
Cochrane, J.H. and L.P. Hansen, (1992), 'Asset pricing explorations for macroeconomics (with discussion)', NBER Macroeconomics Annual, (MIT Press, Cambridge, MA) 115-182.
Constantinides, G., (1990), 'Habit formation: a resolution of the equity premium puzzle', Journal of Political Economy, 98, pp. 519-43.
Craine, R. and V. Martin, (2004), 'Monetary policy shocks and security market responses', Working Paper, University of California at Berkeley.
Dai, Q., (2000), 'From Equity Premium Puzzle to Expectations Puzzle: A General Equilibrium Production Economy with Stochastic Habit Formation', working paper, New York University.
Douch, M., (2009), 'Equity Premium in Small Open Economy', Euro-Mediterranean Economics and Finance Review, 4 (2), pp. 53-69.
Duffee, G. R., 'Information in (and Not in) the Term Structure,' Unpublished Paper, Haas School of Business, University of California-Berkeley.
Engle, R. F., (2002), 'Dynamic Conditional Correlation: A Simple Class of Multivariate GARCH Models', Journal of Business and Economic Statistics, 20, pp. 339-350.
Fama, E. F., (1998), 'Market Efficiency, Long-term Returns, and Behavioral Finance', Journal of Financial Economics, 49, 283-306.
Fama, E. F., and K.R. French, (1989), 'Business conditions and expected returns on stocks and bonds', Journal of Financial Economics, 25, pp. 23-50.
Ferson W. E. and G. M. Constantinides, (1991), 'Habit persistence and durability in aggregate consumption', Journal of Financial Economics, 29, pp. 199-240.
Ferson, W.E., and J.J. Merrick, (1987), 'Non-stationarity and stage-of-the-business cycle effects in consumption-based asset pricing models', Journal of Financial Economics 18, pp. 127-146.
Forni, M. and M. Lippi, (1997), 'Aggregation and the Microfoundations of Dynamic Macroeconomics', Oxford University Press, Oxford, U.K.
Geweke, J., (1977), 'The dynamic factor analysis of economic time series', In Dennis J. Aigner and Arthur S. Goldberger (eds.) Latent Variables in Socio-Economic Models (Amsterdam: North-Holland).
Hansen, L. and K. Singleton, (1982),'Generalized Instrumental Variables Estimation of Nonlinear Expectations Models', Econometrica, 50 (5), pp. 1269-1286.
-----, (1983), 'Stochastic Consumption, Risk Aversion and the Temporal Behavior of Asset Returns', Journal of Political Economy, 91 (2), pp. 249-265.
-----, (1984), 'Erratum of the article "Generalized Instrumental Variables Estimation of Nonlinear Expectations Models', Econometrica, 52 (1), pp. 267-268.
Heaton, J., (1995), 'An empirical investigation of asset pricing with temporally dependent preference specification', Econometrica, 63 (3), pp. 681-717.
Heffetz, O., and R. H. Frank, (2008), 'Preferences for status: Evidence and Economic Implications', Handbook of Social Economics.
Hopkins, E. and T. Kornienko, (2004), 'Running to Keep in the Same Place: Consumer Choice as a Game of Status', American Economic Review, pp. 1085-1107.
Jagannathan, R., and Z. Wang, (1993), 'The CAPM is alive and well', Staff report 165, Federal Reserve Bank of Minneapolis.
Jermann, U. J., (1998), 'Asset Pricing in Production Economies', Journal of Monetary Economics, 41, pp. 257-275.
Krueger, A.B., (1996), 'Do Markets respond More to More Reliable Labor Market Data? A Test of Market Rationality', NBER Working Paper 5769.
Kuttner, K. N., (2001), 'Monetary policy surprises and interest rates: Evidence from the Fed Funds futures market', Journal of Monetary Economics, pp. 523-544.
Lettau, M. and S. C. Ludvigson, (2010), 'Measuring and Modeling Variation in the Risk-Return Trade-off', Handbook of Financial Econometrics, ed. by Yacine Ait-Sahalia and Lars P. Hansen, Elsevier Science B.V., North Holland, Amsterdam, 1, pp. 617-690.
Lucas, R. E., (1978), 'Asset Prices in an Exchange Economy', Econometrica, 46, pp. 1429-1445,
Ludvigson, S. C., and S. Ng, (2009), 'Macro Factors in Bond Risk Premia', The Review of Financial Studies, 22 (12), pp. 5027-5067.
Mele, A., (2007), 'Asymmetric stock market volatility and the cyclical behavior of expected returns', Journal of financial economics, 86 (2), pp. 446-478.
Merha, R., (2006), 'The Equity Premium Puzzle: A Review', Fondations and Trends in Finance, 2 (1), pp. 1-81.
Mehra, R. and E. Prescott, (1985), 'The equity premium: a puzzle', Journal of Monetary Economics, 15, pp. 145-61.
Mönch, E., (2007), 'Forecasting the Yield Curve in a Data-Rich Environment: A No-Arbitrage Factor-Augmented VAR Approach', Unpublished Paper, Federal Reseve Bank of New York.
Mulligan, C., (2002), 'Capital, Interest, and Aggregate Intertemporal Substitution', Working Paper # w9373, National Bureau of Economic Research.
-----, (2004), 'Robust Aggregate Implications of Stochastic Discount Factor Volatility', Working Paper # w10210, National Bureau of Economic Research.
Normandin, M. and P. St-Amour, (1998), 'Substitution, Risk Aversion, Taste Shocks, and Equity Premia', Journal of Applied Econometrics, 13, pp. 265-281.
Rigobon, R. and B. Sack, (2004), 'The Impact of Monetary Policy on Asset Prices', Journal of Monetary Economics, 51 (8), pp. 1553-1575.
Routledge, B. and S. Zin, (2004), 'Model Uncertainty and Liquidity', working paper, Carnegie Mellon University.
Samuelson, P.A., (1989), 'A Case at Last for Age-phased Reduction in Equity', Proceedings of the National Academy of Sciences, Washington, DC.
Sargent, T. J. and C. A. Sims, (1977), 'Business cycle modelling without pretending to have too much a priori economic theory', In Cristopher A. Sims (ed.) New Methods in Business Research (Minneapolis: Federal Reserve Bank of Minneapolis).
Stock, J.H. and M.W. Watson, (1999), 'Forecasting Inflation', Journal of Monetary Economics, 44, pp. 293-335.
-----, (2002), 'Forecasting Using Principal Components from a Large Number of Predictors', Journal of the American Statistical Association, 97, pp. 1167-1179.
-----, (2005), 'Forecasting with many predictors', Unpublished Manuscript. Princeton University, Princeton, NJ (prepared for The Handbook of Economic Forecasting).
Sundaresan, S. M., (1989), 'Intertemporally dependent preferences and the volatility of consumption and wealth', Review of Financial Studies, 2, pp. 73-89.
Watcher, J., (2006), 'A consumption based model of the term structure of interest rates', Journal of Financial Economics, 79, pp. 365-399.
Woehrmann, P., W. Semmler and M. Lettau, (2005), 'Nonparametric Estimation of the Time-varying Sharpe Ratio in Dynamic Asset Pricing Models', IEW - Working Papers iewwp225, Institute for Empirical Research in Economics.
Yogo, M., (2008), 'Asset Prices Under Habit Formation and Reference-Dependent Preferences', Journal of Business and Economic Statistics, 26(2), pp. 131-143.