Pursuing the equity risk premium : intertemporal substitution and economic growth

Risk premium measures in general equilibrium asset pricing models do not absorb all the risk attributable to risky assets. Some risk is left unaccounted for in the expected intertemporal rate of substitution term. Four risk premium measures that do absorb all the risk attributable to risky assets are developed here. Two of the risk premium measures are level measure and are formulated in prices. The other two are formulated in returns. All the four measures are closely related to asset prices. It is shown mainly by simulations that it is important to model the underlying real economy; it is not sufficient to just consider the financial side. As the underlying economy the simple `Ak-model' of endogenous growth is considered. It is expanded to include multiple sectors, stochastic production, and an asset market. The cases of full mobility and strict immobility of capital are considered. An implication of the full mobility case is that expected financial returns do not have to equal expected productivities. The mean of the so-called equity risk premium puzzle can easily be generated even though the model with full capital mobility is a frictionless Arrow-Debreu economy with production. The model with full capital mobility is estimated on U.S. data (1900-1970) using GMM estimation. The estimated preference parameters are very `good'. A risk premium 2% -points above the observed risk premium can be generated with the estimated parameters.