The problem, called the "equity premium puzzle
", is that observed rates of return on equity are "excessive", i.e.
Using the insight that search and matching frictions affect asset pricing through a liquidity premium, Lagos (2010) used a third-generation model to address the equity premium puzzle
and the risk-free rate puzzle.
Deliberations on the stock market participation puzzle may provide with the necessary inputs for solving the equity premium puzzle
given by Mehra and Prescott (1985).
"Habit Formation: A Resolution of the Equity Premium Puzzle
." Journal of Political Economy 98 (June): 519-43.
Coverage includes an introduction to modern asset pricing, the authors' new structural theory and its application to the equity premium puzzle
, use of the structural theory to deal with an enlarged portfolio space that includes non-tradable assets, discussion of asset pricing problems including both bottom-up and the top-down investment methodologies, and the relationship of the portfolio insurance with option and consumption-based asset pricing models.
The fact that the model in this paper produced an equity premium higher than the actual one is evidence that the equity premium puzzle
(Mehra and Prescott 1985) does not show up in this paper's model.
Habit forming preferences have been notably successful in solving the equity premium puzzle
. One of their most popular representations is due to Abel (1990, 1999, 2006), who shows that an asset pricing model with relative habits can account for financial regularities that can not be explained by standard models.
In discussing risk aversion, the authors hint at the equity premium puzzle
Since Shiller (1982) and Mehra and Prescott (1985) questioned why the gap between the rates of returns from stocks and bonds is so large, the equity premium puzzle
has attracted the attention of many economists.
Liquidity can thus play a role in resolving a number of asset pricing puzzles such as the small-firm effect, the equity premium puzzle
, and the risk-free rate puzzle.
These results help explain why consumption covariance with equity returns is so low, giving rise to the equity premium puzzle