Institutional Volatility and the Equity Premium Puzzle: A Dynamic Asset Pricing Framework for OECD Economies

Heng-Fu Zou ()

No 775, CEMA Working Papers from China Economics and Management Academy, Central University of Finance and Economics

Abstract: This paper develops a novel institution-based asset pricing model to address the longstanding equity premium puzzle within the context of OECD economies. We endogenize institutional quality -- capturing property rights, rule of law, and political stability -- as a capital-like state variable subject to stochastic shocks, depreciation, and investment. Building on recursive utility and production-based frameworks, we derive the stochastic discount factor (SDF) and demonstrate how institutional volatility amplifes consumption risk and increases equity premia. Our analytical results and numerical simulations show that economies with stronger and more stable institutions exhibit lower risk premia and smoother asset returns, while institutional uncertainty generates excess volatility and persistent return differentials. Empirical proxies -- including political risk indices, rule-of-law scores, and policy uncertainty measures -- confirm the model's predictions across OECD stock markets. This approach not only helps resolve the equity premium puzzle but also highlights the macro financial significance of investing in and protecting institutional capital.

Keywords: Institutional asset pricing; equity premium puzzle; stochastic discount factor; rule of law; political risk; institutional capital; OECD economies; recursive utility; production-based model; global financial stability (search for similar items in EconPapers)
Pages: 18 pages
Date: 2025-07-14
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