What puzzles? : new insights in asset pricing

Abstract

Motivated by the problems of the conventional model in rationalizing izing market data, we derive the equilibrium interest rate and risk premiums using recursive utility in continuous time. In a representative- agent framework our model allows for the separation of risk aversion from the time preference. We demonstrate how this separation gives new insights in asset pricing: The expressions for risk premiums com- bine the market-based CAPM with the consumption-based CAPM. The equilibrium real interest rate now combines characterizations of preferences and market returns. This model explains both the Equity Premium Puzzle and the Risk-Free Rate Puzzle with good margin, and give solutions consistent with early resolution of uncertainty.