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Informational Asymmetry and Market Imperfections: Another Solution to the Equity Premium Puzzle

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  • Zhou, Chunsheng

Abstract

This paper develops an equilibrium asset pricing model to explain the equity premium puzzle and the risk-free rate puzzle by allowing for both market frictions and informational asymmetry. The paper argues that much of the high equity premium in the Mehra and Prescott (1985).sample period can be explained by informational asymmetry among investors and the inability of many investors to diversify their portfolios. With admissible relative risk aversion coefficient γ, the model matches various key statistics quite well. The paper implies that with the development of mutual funds, the equity premium should decline as has been the case since the 1950s.

Suggested Citation

  • Zhou, Chunsheng, 1999. "Informational Asymmetry and Market Imperfections: Another Solution to the Equity Premium Puzzle," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(4), pages 445-464, December.
    • Handle: RePEc:cup:jfinqa:v:34:y:1999:i:04:p:445-464_00
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    Cited by:

    1. Ebrahim, M. Shahid & Mathur, Ike, 2007. "Pricing home mortgages and bank collateral: A rational expectations approach," Journal of Economic Dynamics and Control, Elsevier, vol. 31(4), pages 1217-1244, April.
    2. Bellelah, M.A. & Bellelah, M.O. & Ben Ameur, H. & Ben Hafsia, R., 2017. "Does the equity premium puzzle persist during financial crisis? The case of the French equity market," Research in International Business and Finance, Elsevier, vol. 39(PB), pages 851-866.
    3. Bizid, Abdelhamid & Jouini, Elyès, 2005. "Equilibrium Pricing in Incomplete Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 40(4), pages 833-848, December.
    4. Amadeu DaSilva & Mira Farka & Christos Giannikos, 2011. "Habit Formation in an Overlapping Generations Model with Borrowing Constraints," European Financial Management, European Financial Management Association, vol. 17(4), pages 705-725, September.
    5. Gregory C. Chow, 2003. "Equity Premium and Consumption Sensitivity When the Consumer- Investor Allows for Unfavorable Circumstances," Macroeconomics 0306012, University Library of Munich, Germany.
    6. Chow, Gregory C. & Zheng, Lihui, 2002. "Equity premium and consumption sensitivity when the consumer-investor allows for unfavorable circumstances," Journal of Economic Dynamics and Control, Elsevier, vol. 26(9-10), pages 1417-1429, August.
    7. Shahid Ebrahim, M. & Mathur, Ike, 2001. "Investor heterogeneity, market segmentation, leverage and the equity premium puzzle," Journal of Banking & Finance, Elsevier, vol. 25(10), pages 1897-1919, October.

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