Extrapolative Expectations and the Equity Premium

28 Pages Posted: 11 Oct 2019

See all articles by James J. Choi

James J. Choi

Yale School of Management; National Bureau of Economic Research (NBER)

Thomas M. Mertens

Federal Reserve Bank of San Francisco

Date Written: June 28, 2019

Abstract

Many stockholders irrationally believe that high recent stock market returns predict high future stock market returns. The presence of these extrapolators can help resolve the equity premium puzzle if the elasticity of intertemporal substitution (EIS) is greater than one. In our model, extrapolators’ overreaction to dividend news generates countercyclical expected returns while attenuating their consumption response. The equity premium is high because extrapolators believe stocks are a bad hedge and rational investors’ limited risk-bearing capacity prevents them from fully compensating for extrapolators’ reluctance to hold stocks. We match the U.S. data with a relative risk aversion of 4 and an EIS of 2.

Keywords: equity premium puzzle, riskfree rate puzzle, equity volatility puzzle, noise traders, irrational expectations, adaptive expectations, heterogeneous agents, elasticity of intertemporal substitution

JEL Classification: D51, E44, G12

Suggested Citation

Choi, James J. and Mertens, Thomas M., Extrapolative Expectations and the Equity Premium (June 28, 2019). Available at SSRN: https://ssrn.com/abstract=3462056 or http://dx.doi.org/10.2139/ssrn.3462056

James J. Choi (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Thomas M. Mertens

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

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