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Exact Solutions for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium Puzzle

Andrew Abel ()

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: This paper derives simple closed-form solutions for expected rates of return on stocks and riskless one-period bills under the assumption that shocks to the growth rates of consumption and dividends are generated by a Markov regime-switching process. These closed-form solutions are used to show that the Markov regime-switching process exacerbates the equity premium puzzle and the risk-free rate puzzle. Three empirical examples illustrate the magnitude of the effects of Markov regime switching on equilibrium expected returns.

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Related works:
Journal Article: Exact Solutions for Expected Rates of Return under Markov Regime Switching: Implications for the Equity Premium Puzzle (1994) Downloads
Working Paper: Exact Solutions for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium Puzzle (1992) Downloads
Working Paper: Exact Solutions for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium Puzzle
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