Scandinavian Working Papers in Economics
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Department of Business and Management Science, Norwegian School of Economics (NHH) Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)

No 2004/12:
Jump Dynamics: The Equity Premium and the Risk-Free Rate Puzzles

Knut K. Aase ()

Abstract: The paper develops a consumption based equilibrium model, focusing on the risk premium and the risk-free interest rate. We derive testable expressions for these quantities, and confront these with sample estimates for the 20. century. Our framework is a dynamic model in continuous time, allowing for random jumps at random time points, in addition to diffusion uncertainty. Preferences are time separable and additive.

The classical equity premium puzzle and the risk-free rate puzzle are re-examined. We present values for the parameters of the representative agent's utility function for different values of risk premia and interest rates, calibrated to two first moments of the US-data of the last century. Relatively low values for agents' risk aversion are consistent with the model, but positive values of the subjective interest rate seem harder to fit.

Keywords: Consumption based CAPM; Equilibrium interest rate; The equity premium puzzle; The risk-free rate puzzle; jump/diffusions; (follow links to similar papers)

JEL-Codes: D58; (follow links to similar papers)

28 pages, October 21, 2004

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