Rational Asset Prices

The mean, covariability, and predictability of the return of different classes of financial assets challenge the rational economic model for an explanation. The unconditional mean aggregate equity premium is almost seven percent per year and remains high after adjusting downwards the sample mean premium by intro-ducing prior beliefs about the stationarity of the price–dividend ratio and the ~non!-forecastability of the long-term dividend growth and price–dividend ratio. Recognition that idiosyncratic income shocks are uninsurable and concentrated in recessions contributes toward an explanation. Also borrowing constraints over the investors’ life cycle that shift the stock market risk to the saving middle-aged consumers contribute toward an explanation. A central theme in finance and economics is the pursuit of a unified theory of the rate of return across different classes of financial assets. In particular, we are interested in the mean, covariability, and predictability of the return of financial assets. At the macro level, we study the short-term risk-fre