Some solutions to the equity premium and volatility puzzles

Li, Jinlu (2010): Some solutions to the equity premium and volatility puzzles.

Abstract

In this paper, I adopt an economic equilibrium model utilizing the framework introduced by Mehra and Prescott (1985) when they presented the equity premium puzzle. This model, in the long run and with respect to stationary probabilities, produces results that match the sample values derived from the U.S. economy between 1889 and 1978 as illustrated by the studies performed by Grossman and Shiller (1981), which includes the expected average, standard deviation, and first-order serial correlation of the growth rate of per capita real consumption and the expected returns and standard deviation of equity, risk-free security, and risk premium for equity. Therefore, this model solves the equity premium and volatility puzzles. I also explore the reasons why the equity premium puzzle was caused.

• Item Type: MPRA Paper
• Language: English
• Keywords: The constant relative risk aversion class utility function; risk premium; time discount factor; parameters defining preferences; parameters defining technologies; the equity premium and volatility puzzles.
• Subjects: C - Mathematical and Quantitative Methods > C0 - General > C02 - Mathematical Methods; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C15 - Statistical Simulation Methods: General; E - Macroeconomics and Monetary Economics > E0 - General > E01 - Measurement and Data on National Income and Product Accounts and Wealth ; Environmental Accounts

References

Arrow, K. and Lind, R. ‘Uncertainty and the Evaluation of Public Investment Decisions’,American Economic Review, vol. 60, no. 2, (1970), 364–78.

Bansal, R. and Coleman, J. ‘A Monetary Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles’, Journal of Political Economy, vol. 104, no. 6, (1996), 1135–71.

Benartzi, S. and Thaler, R. ‘Myopic Loss Aversion and the Equity Premium Puzzle’, Quarterly Journal of Economics, vol. 110, (1995), 73–92.

Barro R. J. ‘Rare Disaster and Asset Markets in the Twentieth Century’, Working paper, (2009).

Brown, S., Goetzmann, W. and Ross, S. ‘Survival’, Journal of Finance, vol. 50, (1995), 853–87.

Cecchetti, S., Lam, P.-S., and Mark, N. ‘Asset Pricing With Distorted Beliefs: Are Equity Returns Too Good To Be True?’, American Economic Review, vol. 90, (2000), 787–805.

Chabi-Yo, F. ‘Expaining the idiosyncratic volatility using stochastic discount factors’, Fisher College of Business, Ohio State University,(2009)

Constantinides, G. ‘Habit Formation: A Resolution of the Equity Premium Puzzle’, Journal of Political Economy, vol. 98, no. 3, (1990), 519–43.

——, Donaldson, J. and Mehra, R. ‘Junior can’t Borrow: A New Perspective on the Equity Premium Puzzle’, Quarterly Journal of Economics, vol. 117, no. 1, (2002), 269–96.

De Long, J.B., Shleifer, A., Summers, L.H. and Waldman, R.J. 1990, ‘Noise Trader Risk in Financial Markets’, Journal of Political Economy, vol. 98, August, pp. 703–38.

Epstein, L. and Zin, S.E. “First-Order” Risk Aversion and the Equity Premium Puzzle’, Journal of Monetary Economics, vol. 26, no. 3, (1990), 387–407.

Gabaix, X. and Laibson, D. ‘The 6D Bias and the Equity Premium Puzzle’, Harvard Institute of Economic Research Paper no. 1947, (2001).

Geanakoplos, J., Mitchell, O. and Zeldes, S.P. ‘Would a Privatized Social Security System Really Pay a Higher Rate of Return?’ Columbia Graduate School of Business,(1998), 98–03.

Gneezy, U., Kapteyn, A. and Potters, J. ‘Evaluation periods and asset prices in a market experiment’, Journal of Finance, vol. 58, (2003), 821–838.

Guvenen Fatih, “A Parsimonious Macroeconomic Model for Asset Pricing”, Economitrica, Vol. 77, No. 6, (2009), 1711-1740.

Jagannathan, R., McGrattan, E.R. and Scherbina, A. ‘The Declining US Equity Premium’, Federal Reserve Bank of Minneapolis Quarterly Review, vol. 24, no. 4, (2001), 3–19.

Jensen, M. ‘The Takeover Controversy: Analysis and Evidence’, Midland Corporate Finance Journal, vol. 4, no. 1, (1986), 6–32.

Kahneman, D. and Tversky, A. ‘Prospect Theory: An Analysis of Decision Under Risk’, Econometrica, vol. 47, no. 2, (1979), 263–291.

Kocherlakota, N. ‘The Equity Premium: It’s Still a Puzzle’, Journal of Economic Literature,vol. 34, no. 1, (1996),42–71.

Lucas, R. Models of Business Cycles, Basil Blackwell, New York, (1987).

Mankiw, N.G. ‘The Equity Premium and the Concentration of Aggregate Shocks’, Journal of Financial Economics, vol. 17, (1986), 211–19.

Marsh, P. ‘Short-termism on Trial’, Institutional Fund Managers Association, London, (1990).

Mayston, D. ‘The Private Finance Initiative in the NHS: An Unhealthy Development in New Public Management?’ Financial Accountability and Management, vol. 15, no. 3/4, (1999),249–74.

Mehra, R. ‘The Equity Premium: Why is it a Puzzle?’, NBER Working Paper 9512 (2003).

—— and Prescott, E. ‘The Equity Premium: A Puzzle’, Journal of Monetary Economics, vol. 15,no. 2, (1985), 145–61.

—— and ——‘The Equity Premium in Retrospect’, NBER Working Paper 9525 (2003).

Merton, R. A simple model of capital market equilibrium with in information, The Journal of Finance, Vol. XLII. No.3 (1987), 483-510.

Otrok, C., Ravikumar, B. and Whiteman, C.H. ‘Habit Formation: A Resolution of the Equity Premium Puzzle?’, Journal of Monetary Economics, vol. 49, no. 6, (2002), 1261–88.

Palomino, F. ‘Noise Trading in Small Markets’, Journal of Finance, vol. 51, (1996), 1537–50. Quiggin, J. ‘The Risk Premium for Equity: Implications for Proposed Diversification of the Social Security Fund’, American Economic Review, vol. 92, no. 4, (2002), 1104-15.

—— and ——‘Public Investment and the Risk Premium for Equity’, Economica, vol. 70,no. 277, (2003), 1–18.

Rietz, T. ‘The Equity Risk Premium: A Solution’, Journal of Monetary Economics, vol. 22,no. 1, (1988), 117–31.

Shiller, R. Market Volatility, MIT Press, Cambridge, Mass. and London (1989).

Shleifer, A. and Vishny, R. ‘Equilibrium Short Horizons of Investors and Firms’, American Economic Review, vol. 80, no. 2, (1990), 148–53.

Stiglitz, J. ‘Using Tax Policy to Curb Speculative Short-Term Trading’, Journal of Financial Services Research, vol. 3, (1989), 101–15.

Swan, P. ‘Optimal Portfolio Balancing under Conventional Preferences and Transaction Costs Explains the Equity Premium Puzzle’, unpublished working paper, University of New South Wales (2005).

ul Haq, M., Kaul, I. and Grunberg, I. The Tobin Tax: Coping With Financial Volatility, Oxford University Press, Oxford, UK (1996).

Weil, P. ‘The Equity Premium Puzzle and the Risk-Free Rate Puzzle’, Journal of Monetary Economics, vol. 24, (1989), 401–21.

Weitzman, M. ‘The Bayesian Family of Equity Non-Puzzles’, mimeo Harvard University (2004).

Uhlig, H. “Macroeconomics and Asset Markets: Some Mutual Implications,” Unpublished Manuscript, University of Chicago, (2006).

—— “Leisure, Growth, and Long-run Risk,” Unpublished Manuscript, University of Chicago,(2007).