Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

Abstract: Motivated by the problems of the conventional model in rationalizing 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 combine 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.

Keywords: The equity premium puzzle; the risk-free rate puzzle; recursive utility; early resolution; utility gradients; dynamic programming; The Stern Review

JEL-codes: D51; D53; D90; E21; G10; G12

34 pages, November 16, 2012

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