Equity premium puzzle Assignment Example | Topics and Well Written Essays - 1250 words

Equity premium puzzle - Assignment Example Financial markets analysis shows those equity premiums puzzle still remain a reality with modifications to the assumed preferences and imperfections in the model of risk aversion. There have been some difficulties in the calibration used in the analysis and existence of a substantial equity premium (Lucas 1429). Equity premium and risk free rate puzzles The value premium states that for possible qualities of the danger repugnance coefficient, the contrast of the needed rate of profit for money markets and the riskless rate of premium is too huge, given the watched minor fluctuation of the development rate of capitalization. This puzzle is resolved in the wider context of an economy with rational expectations once the separable time preference is relaxed to allow adjacent complementarities in consumption. On the other hand, given that a large equity premium implies that investors get a high risk; the standard models of preferences in turn imply that they do not like growth that much. Although treasury bills may offer low returns, individuals forgo the consumption at a sufficiently fast rate as they prefer it safe in order to generate the per capita consumption which is average. The risk free rate puzzle states that although individuals like consumption to be very smooth, and where the risk free rate is very low, they still save enough for the per capita consumption to grow rapidly (Lucas 1430). Equity premium and risk free rate puzzles are robust and are explained peculiarities of an individual behavior and asset market structure. Individuals have preferences which are attached and associated with the standard utility functions applied in macroeconomics. The preferences maximize the expected discounted value of utilities generated by the power utility function. In addition, asset markets are complete, where individuals can have insurance contracts for any emergent unforeseen event in the market. Asset trading also constitutes no cost, taxes and fees in brokerage are assumed to be insignificant for this purpose. Investors either find it highly reluctant for consumption risk or stocks trading, and more costly than trading of bonds. The risk free rate puzzle shows that people save even when the returns are low, with equity puzzle demonstrating why individuals are so averse to the risks associated with stock returns, proving the large gaps in understanding of macroeconomics (Lucas 1434). In an attempt to describe and resolve these puzzles in an economy, some scholars explain that it is useful to review the basics of asset pricing. Applying the famous Capital Asset Pricing Model (CAMP), it assumes a perfect correlation between stock returns and a consumption stream of typical investors. Applying this model in an attempt to resolve the puzzle, financial analysts are allowed to calculate and measure the financial security risk. With the use of CAPM, a security risk can be measured using the covariance of the return with the per capita consumption . The difference in the covariance of the returns and the consumption growth is large. This clearly explains the enigma of the equity premium where in a quantitative sense the stocks are not really riskier in comparison with the treasury bills