Risk Based Explanations of the Equity Premium
This essay reviews the family of models that seek to provide aggregate risk based explanations for the empirically observed equity premium. Theories based on non-expected utility preference structures, limited financial market participation, model uncertainty and the small probability of enormous losses are detailed. We impose the additional requirements that candidate models yield consistent inter temporal portfolio choice and that a representative agent can be constructed which is independent of the underlying heterogeneous economy's initial wealth distribution. While many models are able to replicate a wide variety of financial statistics including the premium, few satisfy these latter criteria as well.
We are grateful to Francisco Azeredo, Nick Barberis, Ravi Bansal, Francisco Gomes, George Constantinides, Vito Gala, Alok Khare and Edward Prescott for their comments on earlier drafts of this chapter. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
“Risk Based Explanations of the Equity Premium” (with J.B Donaldson) Handbook of Investments: The Handbook of the Equity Risk Premium. ed. by Rajnish Mehra, Elsevier, Amsterdam, 2008, pp 37- 100.