Exact Solutions for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium Puzzle

31 Pages Posted: 9 Jan 2007  

Andrew B. Abel

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Date Written: June 1992

Abstract

This paper derives simple closed-form solutions for expected rates of return on stocks and riskless one-period bills under the assumption that shocks to the growth rates of consumption and dividends are generated by a Markov regime-switching process. These closed-form solutions are used to show that the Markov regime-switching process exacerbates the equity premium puzzle and the risk-free rate puzzle. Three empirical examples illustrate the magnitude of the effects of Markov regime switching on equilibrium expected returns.

Suggested Citation

Abel, Andrew B., Exact Solutions for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium Puzzle (June 1992). NBER Working Paper No. w4110. Available at SSRN: https://ssrn.com/abstract=476193

Andrew B. Abel (Contact Author)

National Bureau of Economic Research (NBER)

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