The Equity Premium Puzzle and the Riskfree Rate Puzzle
Abstract
This paper studies the implications for general equilibrium asset pricing of a class of Kreps-Porteus nonexpected utility preferences characterized by a constant intertemporal elasticity of substitution and a constant, but unrelated, coefficient of relative risk aversion. It is shown that relaxing the parametric restriction on tastes imposed by the time-additive expected utility specification does not suffice to solve the Mehra-Prescott (1985) equity premium puzzle. An additional puzzle — the risk-free rate puzzle — emerges instead: why is the risk-free rate so low if agents are so averse to intertemporal substitution?
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