Stable paretian distribution, return generating processes and habit formation—The implication for equity premium puzzle

Abstract

We study an asset pricing model with stable Paretian shocks to solve the equity premium puzzle. We extend the model with different return generating processes for consumption and dividends, relaxing the strong assumption made in previous studies that aggregate dividends are equal to consumption. The model derives solutions for asset prices and returns. Solutions are provided for the CRRA (constant relative risk aversion) utility function and habit formation utility function. We also prove the convergence of the solution under the maximally negative skewness condition and show that this new model can generate higher risk premia. With more realistic assumptions about the exogenous endowments and utility functions, our new model improves the explanatory power of fat-tailed models with stable shocks for the equity premium, thus providing an alternative approach to resolving the equity premium puzzle.