2003, Risk Aversion, Regimes, and Returns: Revisiting the Equity Premium Puzzle, working paper

We reexamine the level and volatility of the equity premium in an overlapping generations environment with time-varying risk aversion. When calibrated with reasonable historical govern-ment bond and equity market data, our model has the potential to match not only the observed equity premium level, but also its volatility when the population in the economy has an average risk aversion coefficient of about eight. A reasonably large equity premium can be reproduced with two regimes that have risk aversion coefficients that are low and not too disparate. Our numerical results demonstrate that the equity premium and its volatility are increasing in the degree of risk aversion and investor heterogeneity, and decreasing in the savings motive arising from positive income shocks. We also demonstrate that different sets of “reasonable ” calibration inputs can lead to equity premia and returns that are off by an order of magnitude. To solve the equity premium, riskfree rate and volatility puzzles simultaneously, one needs a larger dispersion in risky asset earnings than what is empirically observed. ∗Preliminary and incomplete. Comments welcome