Title: The Equity Premium Puzzle and the Risk-Free Rate Puzzle at Long Horizons.

Co-author: David Marshall, Federal Reserve Bank of Chicago.

Status: Published in Macroeconomic Dynamics, 1997, Volume 1, Number 2, pages 452-484.


The failure of consumption based asset pricing models to match the stochastic properties of the equity premium and the risk-free rate has been attributed by some authors to frictions, transaction costs or durability. However, such frictions would primarily affect the higher frequency data components: consumption-based pricing models that concentrate on long-horizon returns should be more successful.

We consider two consumption-based models: time-separable utility, and the habit model of Constantinides (1990). We estimate a vector ARCH model that includes the pricing kernel and the equity return, and use the fitted model to assess the model's implications for the equity premium and for the risk-free rate. Neither model performs well at a quarterly horizon, but at longer horizons the Constantinides model can match the mean and the variance of the observed equity premium, captures time-variation of the equity premium, and can better match the observed risk-free rate. We conclude that the equity premium and risk-free rate puzzles are primarily problems for shorter-horizon returns.

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