Equity Premium Puzzle or Faulty Economic Modelling?

Abstract

In this paper, we revisit the equity premium puzzle reported in 1985 by Mehra and Prescott. We show that the large equity premium that they report can be explained by choosing a more appropriate distribution for the return data. We demonstrate that the high-risk aversion value observed by Mehra and Prescott may be attributable to the problem of fitting a proper distribution to the historical returns and partly caused by poorly fitting the tail of the return distribution. We describe a new distribution that better ts the return distribution and when used to describe historical returns can explain the large equity risk premium and thereby explains the puzzle.

Keywords: Rational Finance, Equity Premium Puzzle, Normal compound inverse Gaussian distribution

JEL Classification: G00, G14,