Informational asymmetry and market imperfections: Another solution to the equity premium puzzle

This paper develops an equilibrium asset pricing model to explain the equit y premium puzzle and the risk-free rate puzzle by allowing for both market frictions and informational asymmetry. The paper argues that much of the hi gh equity premium in the Mehra and Prescott (1985) sample period can be exp lained by informational asymmetry among investors and the inability of many investors to diversify their portfolios. With admissible relative risk ave rsion coefficient gamma, the model matches various key statistics quite wel l. The paper implies that with the development of mutual funds, the equity premium should decline as has been the case since the 1950s.