CRASH STATES AND THE EQUITY PREMIUM - SOLVING ONE PUZZLE RAISES ANOTHER

This paper examines the behavior of asset returns as predicted by the consumption-based capital asset pricing model within an artificial eco nomy that includes a low probability, crash state in consumption and d ividends. It is demonstrated that the behavior of agents' intertempora l marginal rate of substitution in such an economy is consistent with the Hansen and Jagannathan (1991) frontier even though the consumption process in the model is calibrated to actual data, preferences are ti me separable, and agents' relative risk aversion is restricted to mode rate levels. Moreover, as demonstrated by Rietz (1988), the crash-stat e economy can replicate the mean of excess returns on equity, i.e. the equity premium. However, the model severely underpredicts the volatil ity of excess returns. (C) 1998 Elsevier Science B.V. All rights reser ved.