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Disappointment Aversion as a Solution to the Equity Premium and the Risk-Free Rate Puzzles

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Marco Bonomo
René Garcia

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Abstract

In this paper, we match both the first and the second moments of the equity premium and the risk-free rate by endowing the agents in the economy with disappointment aversion preferences and by making the joint process of consumption and dividends follow a Hamilton's (1989) Markov switching model. The interesting feature about the model proposed in this paper is that we need both disappointment aversion and a Markov switching endowment to match the first and second moments of both real and excess returns. With disappointment averse agents but a joint random walk for consumption and dividend growth rates, the average equity premium produced by the model is in the order of 2.5% compared with 5.3% in our sample. With isoelastic preferences but a bivariate three-state Markov switching model for consumption and dividend growth rates, the equity premium is 1.7% for a coefficient of relative risk aversion of 8 and a discount factor of 0.98, while the standard deviations for both the equity premium and the risk-free rate are close to the observed ones. The mean of the risk-free rate stands however very high at 13%. For a disappointment averse consumer, who weights more bad outcomes than good ones (where bad and good are defined with reference to a certainty equivalent measure of a gamble), it is precisely the existence of a bad state that lowers the equilibrium risk-free rate and increases the mean stock return, thereby producing the desired equity premium.

Dans le présent article, nous reproduisons les premier et deuxième moments de la prime de risque sur les actions et du taux de risque en dotant les agents dans notre économie de préférences exhibant de l'averison pour la déception et en adoptant un modèle à changements de régime markoviens (Hamilton (1989)) pour le processus conjoint de la consommation et des dividendes. Le modèle proposé a la particularité intéressante de devoir combiner l'aversion pour la déception et une dotation à changements de régime markoviens pour pouvoir reproduire les premier et deuxième moments des rendements réels et excédentaires. Avec des agents dotés d'averison pour la déception0501s une promenade aléatoire conjointe pour les taux de croissance de la consommation et des dividendes, la prime de risque moyenne sur les actions produites par le modèle est de l'ordre de 2,5 % par rapport à 5,3 % dans notre échantillon. Avec des préférences isoélastiques0501s un modèle bivarié à changement de régime markovien à 3 états pour les taux de croissance de la consommation et des dividendes, la prime de risque sur les actions est de 1,7 % pour un coefficient d'aversion relative pour le risque de 8 et un facteur d'escompte de 0,98, tandis que les écarts-types de la prime de risque et du taux sans risque sont proches des valeurs observées. La moyenne du taux sans risque est toutefois très élevée à 13 %. Pour un consommateur ayant de l'aversion pour la déception, qui accorde un poids plus important aux mauvaises réalisations de la nature qu'aux bonnes (où bon et mauvais se définissent par un rapport à une mesure d'équivalence certaine d'un enjeu), c'est précisément l'existence d'un mauvais état de la nature qui, à l'équilibre, fait baisser le taux sans risque et augmenter le rendement moyen sur les actions, ce qui produit la prime de risque désirée sur les actions.

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Paper provided by CIRANO in its series CIRANO Working Papers with number 94s-14.

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Date of creation: 01 Oct 1994
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Handle: RePEc:cir:cirwor:94s-14

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Keywords: Equity premium puzzle; Risk-free rate puzzle; Disappointment aversion; Markov switching models; Asset pricing; Recursive utility; 94s-14; Énigme de la prime de rendement sur les actions ; Énigme du taux de l'actif sans risque ; Aversion pour la déception ; Modèles à changements de régime markoviens ; Valorisation des actifs financiers ; Utilité récursive;

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Find related papers by JEL classification:
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

References listed on IDEAS
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  2. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April. [Downloadable!] (restricted)
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  3. Kim, Myung Jig & Nelson, Charles R & Startz, Richard, 1991. "Mean Reversion in Stock Prices? A Reappraisal of the Empirical Evidence," Review of Economic Studies, Blackwell Publishing, vol. 58(3), pages 515-28, May. [Downloadable!] (restricted)
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  4. Cecchetti, Stephen G & Mark, Nelson C, 1990. "Evaluating Empirical Tests of Asset Pricing Models: Alternative Interpretations," American Economic Review, American Economic Association, vol. 80(2), pages 48-51, May. [Downloadable!] (restricted)
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  6. Hansen, Bruce E, 1992. "The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages S61-82, Suppl. De. [Downloadable!] (restricted)
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  19. Segal, Uzi & Spivak, Avia, 1990. "First order versus second order risk aversion," Journal of Economic Theory, Elsevier, vol. 51(1), pages 111-125, June. [Downloadable!] (restricted)
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  20. Andrew B. Abel, . "Exact Solutions for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium Puzzle," Rodney L. White Center for Financial Research Working Papers 9-92, Wharton School Rodney L. White Center for Financial Research.
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  21. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  23. MArco Antonio Bonomo & Rene Garcia, 1992. "Can a well-fitted equilibrium asset pricing model produce mean reversion?," Textos para discussão 270, Department of Economics PUC-Rio (Brazil). [Downloadable!]
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  24. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. René Garcia & Éric Renault, 1998. "Risk Aversion, Intertemporal Substitution, and Option Pricing," CIRANO Working Papers 98s-02, CIRANO. [Downloadable!]
  2. Edward Amadeo, 1994. "Distributive and welfare effects of inflation and stabilization," Textos para discussão 312, Department of Economics PUC-Rio (Brazil). [Downloadable!]
  3. René Garcia & Richard Luger & Éric Renault, 2001. "Empirical Assessment of an Intertemporal Option Pricing Model with Latent Variables (Note : New version February 2002) / Empirical Assessment of an Intertemporal Option Pricing Model with Latent Varia," CIRANO Working Papers 2001s-02, CIRANO. [Downloadable!]
  4. Edward Amadeo, 1993. "An economist's political view of democratization in Brazil," Textos para discussão 310, Department of Economics PUC-Rio (Brazil). [Downloadable!]
  5. René Garcia & Richard Luger & Éric Renault, 2001. "Asymmetric Smiles, Leverage Effects and Structural Parameters," CIRANO Working Papers 2001s-01, CIRANO. [Downloadable!]
    Other versions:
  6. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1994. "The Implications of First-Order Risk Aversion for Asset Market Risk Premiums," NBER Working Papers 4624, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  7. Fabio Canova & Gianni De Nicoló, 2003. "The Properties of the Equity Premium and the Risk-Free Rate: An Investigation Across Time and Countries," IMF Staff Papers, Palgrave Macmillan Journals, vol. 50(2), pages 4. [Downloadable!] (restricted)
  8. Edward Amadeo & José Marcio Camargo, 1994. "Institutions and the labor market in Brazil," Textos para discussão 315, Department of Economics PUC-Rio (Brazil). [Downloadable!]
  9. Gustavo Gonzaga, 1993. "Assymmetric employment cycles at the firm level: A dynamic labor demand model and some empirical evidence," Textos para discussão 309, Department of Economics PUC-Rio (Brazil). [Downloadable!]
  10. Claudio Campanale & Rui Castro & Gian Luca Clementi, . "Asset Pricing in a Production Economy with Chew-Dekel Preferences," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics. [Downloadable!] (restricted)
    Other versions:
  11. Rene Garcia & Richard Luger & Eric Renault, 2004. "Option Prices, Preferences, and State Variables," Emory Economics 0418, Department of Economics, Emory University (Atlanta). [Downloadable!]
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