Abstract
In ‘The Equity Risk Premium: A Puzzle’, Mehra and Prescott (1985) developed an Arrow-Debreau asset pricing model. They rejected it because it could not explain high enough equity risk premia. They concluded that only non-Arrow-Debreu models would solve this ‘puzzle’. Here, I re-specify their model, capturing the effects of possible, though unlikely, market crashes. While maintaining their model's attractive features, this allows it to explain high equity risk premia and low risk-free returns. It does so with reasonable degrees of time preference and risk aversion, provided the crashes are plausibly severe and not too improbable.
Users
Please
log in to take part in the discussion (add own reviews or comments).