Solving the Equity Premium Puzzle by Unifying Economics and Finance

Abstract

The Equity risk-premium and volatility puzzle - is it possible to have a high equity premium and a low risk-free rate with a plausible risk aversion- have received a great deal of attention but beyond this question, the fundamental issues of that puzzle are the followings: what are the economic representations that can provide such results? What are the relevant links between finance and economics? And what should be the consequences for economic decisions makers?

The classic ways to model the financial economy with a representative agent placed in a Lucas tree model, i.e. maximizing consumption-based utility, where fruit is equivalent to dividend and consumption, failed to explain a high equity premium and a low risk free rate. Even more, simple changes in reasoning failed to provide a consistent macroeconomic and finance representation that sticks to reality.

This paper presents a new eco-financial approach based on three major changes: the definition of Wealth and wealth increment and their utility for any agent instead of consumption, a permanent change of equilibrium theory, a more realistic model in which the agents fear much more crises than ordinary fluctuations.

This model borrows two key principles from the model developed in Modigliani and Miller’s seminal papers: firstly an economy with investment opportunities in the market of goods and services and secondly an economy where rational agents always prefer more wealth to less and are indifferent as to whether a given increment to their wealth takes the form of dividend or growth in value .Main changes come from, we generalized this wealth approach to any agent, in a changing of equilibrium world, where crises are much more dreaded than ordinary negative events.

We will show that it is a way to solve the equity premium and to make consistent: macro, micro, finance and reality.