An interrelation of time preference and risk attitude: an application to the equity premium puzzle

Abstract

In the fields of behavioural economics and finance, several researchers show that the time preference of an investor is related to his/her attitude towards risky assets. This article investigates whether the equity premium puzzle laid out in Mehra and Prescott (1985) can be accounted for when this relation is imposed on the representative agent model of asset pricing. Three primary features of our analysis allow us to investigate the relationship. First, we derive an equation satisfied by the rate of time preference. Second, our model can yield an equity premium that is consistent with the observed data even in the standard power utility setting. Third, to fit the observed equity premium, we show that it is required to assume a negative rate of time preference, which is consistent with Kocherlakota (1996) and Brennan and Xia (2001).