Jump Dynamics: The Equity Premium and the Risk-Free Rate Puzzles

The paper develops a consumption based equilibrium model, focusing on the risk premium and the risk-free interest rate. We derive testable expressions for these quantities, and confront these with sample estimates for the 20. century. Our framework is a dynamic model in continuous time, allowing for random jumps at random time points, in addition to diffusion uncertainty. Preferences are time separable and additive. <p> The classical equity premium puzzle and the risk-free rate puzzle are re-examined. We present values for the parameters of the representative agent's utility function for different values of risk premia and interest rates, calibrated to two first moments of the US-data of the last century. Relatively low values for agents' risk aversion are consistent with the model, but positive values of the subjective interest rate seem harder to fit.