Risk Weighted Utility Theory as a Solution to the Equity Premium Puzzle

Thierry Chauveau and Nicolas Nalpas
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Thierry Chauveau: TEAM - Théories et Applications en Microéconomie et Macroéconomie - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, CDC - Caisse des Dépôts et Consignations
Nicolas Nalpas: TEAM - Théories et Applications en Microéconomie et Macroéconomie - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique

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Abstract: In this paper, we formulate a restatement of the theory of choice under uncertainty. As an alternative to the rank-dependent expected utility model, we develop a probability-altering theory in which the transformation of probabilities is weighted by the centerred outcome of the lottery which may be viewed as "pure" risk. Using a weak restriction on the changes of probability measure, we avoid stochastic dominance inconsistency. We examine the main effects of this new approach on financial market equilibrium, especially in terms of Euler stochastic equations. Using such an approach allows for accounting for both high equity risk premia and low risk free rates without unrealistic assumptions upon the values of parameters characterizing the behavior of the representative consumer.

Keywords: probability transformation function; CAPM; equity premium puzzle (search for similar items in EconPapers)
Date: 1999-09
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Published in 1999

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