A New Solution to the Equity Premium Puzzle and the Risk-Free Rate Puzzle: Theory and Evidence

Hideaki Tamura () and Yoichi Matsubayashi ()

No 1422, Discussion Papers from Graduate School of Economics, Kobe University

Abstract: This paper develops a new method for solving both equity premium and risk free rate puzzles based on the standard utility function. The method for solving the equity premium puzzle in accordance with Mehra and Prescott (1985) needs to be simultaneously consistent with the method for solving the risk-free rate puzzle presented by Weil (1989). That is, the reasonable estimated values for the degree of relative risk aversion in the former solution and for the subjective discount rate in the latter solution need to plausibly fall within experiential bounds. This study indicates that a consistent solution is possible for the equity premium and risk-free rate puzzles even when there is a standard constant relative risk aversion (CRRA) type utility function. This solution is possible by formularizing the Euler equation for consumption, considering the precautionary saving effect.

Keywords: equity premium puzzle; risk-free rate puzzle; uncertainty; Euler equation (search for similar items in EconPapers)
JEL-codes: E21 E44 G12 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2014-08
New Economics Papers: this item is included in nep-dge, nep-fmk, nep-mac and nep-upt
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