Cambridge Journals Online

EQUITY-PREMIUM AND RISK-FREE-RATE PUZZLES AT LONG HORIZONS

The failure of consumption-based asset pricing models to match the stochastic properties of the equity premium and the risk-free rate has been attributed by some authors to frictions, transaction costs, or durability. However, such frictions primarily would affect the higher-frequency data components: Consumption-based pricing models that concentrate on long-horizon returns should be more successful. We consider two consumption-based models: time-separable utility, and the habit model of Constantinides. We estimate a vector ARCH model that includes the pricing kernel and the equity return, and use the fitted model to assess the model's implications for the equity premium and for the risk-free rate. Neither model performs well at a quarterly horizon, but at longer horizons the Constantinides model can match the mean and the variance of the observed equity premium, captures time variation of the equity premium, and can better match the observed risk-free rate. We conclude that the equity-premium and risk-free-rate puzzles are primarily problems for shorter-horizon returns.

Footnotes

¹ We thank Steve Cecchetti, Larry Christiano, John Cochrane, George Constantinides, Larry Epstein, Lars Hansen, and an anonymous referee for numerous useful suggestions, and we acknowledge Glenn McAfee for superlative research assistance. Daniel gratefully acknowledges research support from the Center for Research in Security Prices (CRSP) at the University of Chicago. Some results in this paper were previously circulated in a working paper entitled, “Consumption-Based Modeling of Long-Horizon Returns.”