A Further Equity Premium Puzzle

Abstract

Mehra and Prescott (1985) point out that it is difficult to reconcile certain empirical facts about equity and debt returns and the process of consumption growth with reasonable assumptions about the relative rate of risk aversion and the pure rate of time preference, in a conventional infinite-horizon model with an additively separable, constant relative rate of risk aversion (CRRA) utility function. The present note adds the further puzzle that if the mean rate of growth of consumption is not known with perfect certainty in such a model, both stocks and real perpetuities have an infinite price in terms of consumption goods. When maturity-specific claims on real output are introduced, the equity premium is seen to increase without bound at the most distant horizons. These in turn dominate asset pricing, so that the equity premium on claims on all future output is indeed infinite.

Citation

McCulloch, J.H. (2017), "A Further Equity Premium Puzzle", Advances in Pacific Basin Business Economics and Finance (Advances in Pacific Basin Business, Economics and Finance, Vol. 5), Emerald Publishing Limited, Leeds, pp. 19-26. https://doi.org/10.1108/S2514-465020170000001002