Implications for Asset Pricing Puzzles of a Roll-Over Assumption for the Risk-Free Asset

Abstract

The equity risk premium and risk-free rate puzzles are largely resolved by combining persistent uncertainty over the long-term consumption growth rate with analysis of the risk-free asset on a 'roll-over' basis. Under these conditions, cash equivalents are evaluated as a multi-period investment strategy that hedges against adverse growth rate outcomes. The premium on the risky asset is raised and the risk-free rate lowered due to their respective relation with multi-period consumption risk. Historical average asset returns are matched at plausible risk aversion.