‘First-order’ risk aversion and the equity premium puzzle

This paper integrates Yaari's dual theory of choice under uncertainty into a multiperiod context and examines its implications for the equity premium puzzle. An important property of these preferences is that of ‘first-order risk aversion’ which implies, in our model, that the risk premium for a small gamble is proportional to the standard deviation rather than the variance. Since the standard deviation of the growth rate in aggregate consumption is considerably larger than its variance, the model can generate both a small risk-free rate and a moderate equity premium.