The Equity Premium Puzzle: Can Income Help?
21 Pages Posted: 27 Feb 2002
Date Written: February 20, 2002
None of the attempts to solve the equity premium puzzle has proved to be completely successful. In this paper I argue that implementing the income in the utility function can considerably contribute to the explanation of the equity premium puzzle. Empirical evidence supports this idea. Further support is provided by both macroeconomic theory and continuous time modelling. Empirical evidence shows that taking income into consideration could solve the risk free rate puzzle as well. A theoretical model, which includes income and disentangles dividends as a specific form of income, is developed and its discrete and continuous versions are tested with U.S. data. The tests show that the predicted values of risk free return and equity premium are close to the historically observed ones. Thus the model considerably contributes for the solution of the risk free rate puzzle as well.
Keywords: Income, Risk free rate, Equity premium puzzle
JEL Classification: E21, G12
Suggested Citation: Suggested Citation