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.
%0 Journal Article
%1 Rietz:JME:1988
%A Rietz, Thomas A.
%D 1988
%J Journal of Monetary Economics
%K disaster equity-premium
%N 1
%P 117-131
%R http://dx.doi.org/10.1016/0304-3932(88)90172-9
%T The Equity Risk Premium: a Solution
%U http://www.sciencedirect.com/science/article/pii/0304393288901729
%V 22
%X 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.
@article{Rietz:JME:1988,
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. },
added-at = {2014-10-13T22:19:03.000+0200},
author = {Rietz, Thomas A.},
biburl = {https://www.bibsonomy.org/bibtex/246dcfad4382b98464d00e3e2499856d7/fcqms},
description = {The equity risk premium a solution},
doi = {http://dx.doi.org/10.1016/0304-3932(88)90172-9},
interhash = {08b6b6d3ac8e848d289ad5a1d580fd87},
intrahash = {46dcfad4382b98464d00e3e2499856d7},
issn = {0304-3932},
journal = {Journal of Monetary Economics },
keywords = {disaster equity-premium},
number = 1,
pages = {117-131},
timestamp = {2014-10-13T22:19:03.000+0200},
title = {The Equity Risk Premium: a Solution },
url = {http://www.sciencedirect.com/science/article/pii/0304393288901729},
volume = 22,
year = 1988
}