Abstract
We provide an explanation for the high equity premium, the low risk free rate, and related puzzles based on a unifying theme: identifying the risks that firms and households really face. Our main explanation for the high equity premium is that there is a small per- sistent component to changes in dividend growth, which makes equity prices very volatile, and hence a poor insurance instrument. Our main explanation for the low risk free rate is that individuals face not only aggregate risk, but also significant idiosyncratic risk, which in- creases their desire for precautionary saving. These are our only two departures from the model of Mehra and Prescott. As in Mehra and Prescott, preferences are standard; so individuals' desire for consump- tion smoothing remains the main explanatory factor. The model also explains the extreme volatility of stock prices: the price-dividend ratio predicted by the model based on U.S. consumption data from 1891- 2001 has a correlation of 72% with the actual price-dividend ratio in the S&P 500. The model succeeds in explaining the puzzles without assuming unrealistically high risk aversion: relative risk aversion can be ten or less.
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