Abstract: In ‘The Equity Risk Premium: A Puzzle’, Mehra and Prescott (1985) developed an Arrow-Debreau asset pricing model. They rejected it because it could not explain high enough equity risk premia. They concluded that only non-Arrow-Debreu models would solve this ‘puzzle’. Here, I re-specify their model, capturing the effects of possible, though unlikely, market crashes. While maintaining their model's attractive features, this allows it to explain high equity risk premia and low risk-free returns. It does so with reasonable degrees of time preference and risk aversion, provided the crashes are plausibly severe and not too improbable.
Publication Year: 1988
Publication Date: 1988-07-01
Language: en
Type: article
Indexed In: ['crossref']
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Cited By Count: 1305
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