The Total Risk Premium Puzzle

The fundamental PDE for valuing cash flows or cash flow streams is explained. In a complete market, an investor’s optimal wealth satisfies the fundamental PDE, and this provides a means of calculating the optimal portfolio. Risk neutral probabilities and Girsanov’s theorem are explained. Jump processes, including Poisson processes, are introduced. The risk premium of an asset with jump risks depends on covariation of its continuous part with the continuous part of an SDF and the covariation of its discontinuous part with the discontinuous part of an SDF. Portfolio choice with internal habits is characterized. The ability of a representative investor model with an internal habit to explain the equity premium puzzle is discussed.

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Can currency risk be a source of risk premium in explaining forward premium puzzle?

Journal of International Financial Markets Institutions and Money ◽

10.1016/s1042-4431(03)00010-6 ◽

2003 ◽

Vol 13 (4) ◽

pp. 291-311 ◽

Cited By ~ 13

Author(s):

Chu-Sheng Tai

Keyword(s):

Risk Premium ◽

Currency Risk ◽

Forward Premium Puzzle ◽

Forward Premium ◽

Premium Puzzle

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The Uncertainty Premium in an Ambiguous Economy

Quarterly Journal of Finance ◽

10.1142/s2010139211000109 ◽

2011 ◽

Vol 01 (02) ◽

pp. 323-354 ◽

Cited By ~ 17

Author(s):

Yehuda Izhakian ◽

Simon Benninga

Keyword(s):

Risk Aversion ◽

Risk Premium ◽

Equity Premium ◽

Equity Premium Puzzle ◽

Smooth Model ◽

Increasing Risk ◽

Premium Puzzle ◽

Additional Explanation

The uncertainty premium is the premium that is derived from not knowing the sure outcome (risk premium) and from not knowing the precise odds of outcomes (ambiguity premium). We generalize Pratt's risk premium to uncertainty premium based on Klibanoff et al.'s (2005) smooth model of ambiguity. We show that the uncertainty premium can decrease with an increase in decision maker's risk aversion. This happens because increasing risk aversion always results in a lower ambiguity premium. The positive ambiguity premium may provide an additional explanation to the equity premium puzzle.

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