Solution to the Equity Premium Puzzle with Time-Varying Variables

TL;DR

This paper presents a derived model based on the Consumption Capital Asset Pricing Model to address the equity premium puzzle, aligning with empirical risk attitudes and providing robust results.

Contribution

It introduces a model that explains the equity premium puzzle using time-varying variables and risk behavior analysis, consistent with empirical data.

Findings

CRRA values around 4.40 with subjective discount factors 0.97-0.99

Risk attitudes indicate insufficient risk-loving investors in 1977

Model results are robust and validate the proposed solution

Abstract

The article's aim is to provide a solution to the equity premium puzzle with a derived model. The derived model which depends on Consumption Capital Asset Pricing Model gives a solution to the puzzle with the values of coefficient of relative risk aversion around 4.40 by assuming the subjective time discount factors as 0.97, 0.98 and 0.99. CRRA becomes around 4.11 when the subjective time discount factor is assumed 0.96. These values are found compatible with empirical literature. Moreover, the risk-free asset and equity investors are determined as insufficient risk-loving investors in 1977, which can be considered a type of risk-averse behavior. The risk attitude determination also confirms the validity of the model. Hence, it can be stated that calculated values and risk behavior determination demonstrate the correctness of the derived model because results are robust.