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Risk Weighted Utility Theory as a Solution to the Equity Premium Puzzle

Author

Listed:
  • Thierry Chauveau

    (TEAM - Théories et Applications en Microéconomie et Macroéconomie - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, CDC - Caisse des Dépôts et Consignations)

  • Nicolas Nalpas

    (TEAM - Théories et Applications en Microéconomie et Macroéconomie - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique)

Abstract
In this paper, we formulate a restatement of the theory of choice under uncertainty. As an alternative to the rank-dependent expected utility model, we develop a probability-altering theory in which the transformation of probabilities is weighted by the centerred outcome of the lottery which may be viewed as "pure" risk. Using a weak restriction on the changes of probability measure, we avoid stochastic dominance inconsistency. We examine the main effects of this new approach on financial market equilibrium, especially in terms of Euler stochastic equations. Using such an approach allows for accounting for both high equity risk premia and low risk free rates without unrealistic assumptions upon the values of parameters characterizing the behavior of the representative consumer.

Suggested Citation

  • Thierry Chauveau & Nicolas Nalpas, 1999. "Risk Weighted Utility Theory as a Solution to the Equity Premium Puzzle," Post-Print halshs-03591443, HAL.
    • Handle: RePEc:hal:journl:halshs-03591443
    Note: View the original document on HAL open archive server: https://shs.hal.science/halshs-03591443
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    References listed on IDEAS

    as
    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
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    3. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
    4. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    5. Machina, Mark J, 1982. ""Expected Utility" Analysis without the Independence Axiom," Econometrica, Econometric Society, vol. 50(2), pages 277-323, March.
    6. Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-587, May.
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    Full references (including those not matched with items on IDEAS)

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