One trade at a time -- unraveling the Equity Premium Puzzle

TL;DR

This paper investigates the longstanding Equity Premium Puzzle by proposing that understanding the rational design of financial products can resolve the puzzle, supported by an experimentally tested theory.

Contribution

It introduces a novel theory linking financial product design to the Equity Premium Puzzle, supported by experimental validation.

Findings

Understanding product design explains the Equity Premium Puzzle

Experimental tests support the proposed theory

Resolves a 30-year-old economic anomaly

Abstract

Financial markets provide a natural quantitative lab for understanding some of the most advanced human behaviours. Among them is the use of mathematical tools known as financial instruments. Besides money, the two most fundamental financial instruments are bonds and equities. More than 30 years ago Mehra and Prescott found the numerical performance of equities relative to government bonds could not be explained by consumption-based (mainstream) economic theories. This empirical observation, known as the Equity Premium Puzzle, has been defying mainstream economics ever since. The recent financial crisis revealed an even deeper need for understanding financial products. We show how understanding the rational nature of product design resolves the Equity Premium Puzzle. In doing so we obtain an experimentally tested theory of product design.