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Risk Weighted Utility Theory as a Solution to the Equity Premium Puzzle

Author

Listed:
  • Thierry Chauveau

    (TEAM - Université Paris 1 and CDC-Marchés)

  • Nicolas Nalpas

    (TEAM - Université Paris 1)

Abstract

In this paper, we formulate a restatement of the theory of choice under uncertainty. As an alternative to the rank-dependent expected utility model, we develop a probability-altering theory in which the transformation of probabilities is weighted by the centered outcome of the lottery which may be viewed as "pure" risk. Using a weak restriction on the changes of probability measure, we avoid stochastic dominance inconsistency. We examine the main effects of this new approach on financial market equilibrium, especially in terms of Euler stochastic equations. Using such an approach allows for accounting for both high equity risk premia and low risk free rates without unrealistic assumptions upon the values of parameters characterizing the behaviour of the representative consumer

Suggested Citation

  • Thierry Chauveau & Nicolas Nalpas, 1999. "Risk Weighted Utility Theory as a Solution to the Equity Premium Puzzle," Cahiers de la Maison des Sciences Economiques bla99020, Université Panthéon-Sorbonne (Paris 1).
    • Handle: RePEc:mse:wpsorb:bla99020
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    References listed on IDEAS

    as
    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
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    3. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
    4. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    5. Machina, Mark J, 1982. ""Expected Utility" Analysis without the Independence Axiom," Econometrica, Econometric Society, vol. 50(2), pages 277-323, March.
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    More about this item

    Keywords

    probability transformation function; CAPM; equity premium puzzle;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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