Regret-sensitive equity premium

Abstract

In a static Lucas tree economy, we propose a model that the representative agent is sensitive to regret, that is, the agent is affected by not only the actual outcome but also value-differences between actual and foregone consequences. Our model generalizes the classical simple regret model pioneered by Bell (1982) and Loomes and Sugden (1982), and makes it possible to derive the equilibrium asset price and to see when the regret effect decreases the price. To verify that our model predicts sufficient decreases of the equilibrium price to explain the empirically high risk premium, we analyze the data of U.S. stock market and GDP growth rates during 1871–2018. The numerical calculation indicates that the estimated equilibrium price is small enough to explain the equity premium puzzle.