1990_First-order risk aversion and the equity premium puzzle_Larry G.Epstein and Stanley E. Zin.pdf

Journal of Monetary Economics 26 (1990) 387-407. North-Holland ‘First-order’ risk aversion and the equity premium puzzle* Larry G. Epstein Unwerslty of Toronto, Toronto, Ont. M5S IAI, Canada Stanley E. Zin Carnep Mellon Umlws~ty. Ptttshurgh, PA 15213, USA Recerved September 1989, final versron received June 1990 This paper Integrates Yaari’s dual theory of choice under uncertamty into a multiperiod context and examines its imphcations for the equity premium puzzle. An Important property of these preferences IS that of ‘tirst-order risk aversion’ which implies. in our model. that the risk premium for a small gamble is proportronal to the standard deviation rather than the variance. Since the standard devration of the growth rate m aggregate consumptron is considerably larger than Its varrance, the model can generate both a small rusk-free rate and a moderate equity premmm. 1. Introduction It is common practice in macroeconomics and finance to employ a repre- sentative agent model in order to organize aggregate data on consumption and asset returns. Because of the smoothness of aggregate consumption data for the U.S., the way in which the agent’s risk preferences evaluate small gambles about certainty is critical for providing a good fit to the data. On the other hand, the plausibility of utility specifications is often evaluated infor- mally on the basis of their evaluation of moderate or large gambles derived from thought experiments or ‘real world’ risks. Thus it is desirable to have a functional form for risk preferences which can model plausible risk attitudes *We are indebted to Chew Soo Hong and Uzi Segal for valuable discussrons. We have also benefited from comments by Phrllipe Weil and semmar partrcipants at the Federal Reserve Bank of Minneapohs, Stanford Universtty. the Natronal Bureau of Economrc Research, Queen’s University, and Northwestern Universtty. The first author gratefully acknowledges the financial support of the Soci