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The Equity Premium and the Allocation of Income Risk

Discussion Paper 60 | Published March 1, 1992

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Authors

Jean-Pierre Danthine

John B. Donaldson

Rajnish Mehra

The Equity Premium and the Allocation of Income Risk

Abstract

This paper examines the extent to which the equity premium puzzle can be resolved by taking account of the fact that stockholders bear a disproportionate share of output uncertainty. We do this in the context of a non-Walrasian RBC model where risk reallocation is justified by borrowing restrictions. The risk shifting mechanism we propose has the same effect as would arise from a substantial increase in the risk aversion parameter of the representative agent. As with more standard RBC models, it remains that our model is unable to replicate key financial statistics. In particular, the observation that the equity return is more variable than national product cannot be accounted for under standard technology assumptions.