Supply Side Implications of Ambiguity Aversion for Risk Premium and Risk-Free Rate Puzzles

Abstract

Since the 1990s, many economists have taken different approaches towards resolving the risk premium and risk free rate puzzles. Identifying causes of these two puzzles can help investors, regulators and policy makers in finding out determinants of the asset prices in financial markets and thereby shaping the real sector trends in the economy so that to improve their allocations efficiency. Meanwhile, the periodic incidence and prevalance of ambiguity environment in many economies, especially economies with more fragile institutional and economic structures, such as many developing economies, including the Iranian economy, have turned attentions towards highlighting the consequences of ambiguity for investors’ decision-making and policy design by policy makers.Within a parsimonious continuous-time stochastic general equilibrium model including heterogeneous agents with ambiguity aversion, this study shows how by a utility function with constant relative risk aversion coefficient augmented with variable investment opportunities and financial friction, one can still make a more justifiable account for the above dual puzzles. Model calibration indicates that the model fits better with the stylized facts detected for different time periods.

Keywords

• ambiguity
• variable investment opportunities
• continuous-time general equilibrium model
• heterogeneous agents
• equity premium puzzle
• risk free rate puzzle.