Risk premia and term premia in general equilibrium

Abstract

The equity premium consists of a term premium reflecting the longer maturity of equity relative to short-term bills, and a risk premium reflecting the stochastic nature of equity payoffs and the deterministic nature of payoffs on riskless bills. This paper analyzes term premia and risk premia in a general equilibrium model with catching up with the Joneses preferences and a novel formulation of leverage. Closed-form solutions for moments of asset returns are derived. First-order approximations illustrate the effects of parameters and provide an algorithm to match the means and variances of the riskless rate and the rate of return on equity.