Under the rational expectations hypothesis, there exists an objective probability law governing the state process, and economic agents know this law which coincides with their subjective beliefs. This rational expectations hypothesis has become the workhorse in macroeconomics and finance. However, it faces serious difficulties when confronting with asset markets data. Most prominently, Mehra and Prescott (1985) show that for a standard rational, representative-agent model to explain the high equity premium observed in the data, an implausibly high degree of risk aversion is needed, resulting in the equity premium puzzle. Weil (1989) shows that this high degree of risk aversion generates an implausibly high riskfree rate, resulting in the riskfree rate puzzle.
In addition, a number of empirical studies document puzzling links between aggregate asset markets and macroeconomics: Price-dividend ratios move procyclically (Campbell and Shiller (1988a)) and conditional expected equity premia move countercyclically (Campbell and Shiller (1988a) and Fama and French (1989)). Excess returns are serially correlated and mean reverting (Fama and French (1988b) and Poterba and Summers (1988)). Excess returns are forecastable; in particular, the log dividend yield predicts long-horizon realized excess returns (Campbell and Shiller (1988b), Fama and French (1988a)). Conditional volatility of stock returns is persistent and moves countercyclically (Bollerslev et al. (1992)).
In this paper, we develop a representative-agent consumption-based asset-pricing model that helps explain the preceding puzzles simultaneously by departing from the rational expectations hypothesis. Our model has two main ingredients. First, we assume that consumption and dividends follow a hidden Markov regime-switching model. The agent learns about the hidden state based on past data. The posterior state beliefs capture fluctuating economic uncertainty and drive asset return dynamics. Second, and more importantly, we assume that the agent is ambiguous about the hidden state and his preferences are represented by a generalized recursive smooth ambiguity model that allows for a three-way separation among risk aversion, ambiguity aversion and intertemporal substitution.
We propose novel tractable homothetic utility specifications. These specifications nest Epstein-Zin preferences (Epstein and Zin (1989)), smooth ambiguity preferences (Klibanoff et al. (2005,2006)), multiplier preferences (Hansen and Sargent (2001)), and risk-sensitive preferences (Tallarini (2000)) as special cases. Ambiguity aversion is manifested through a pessimistic distortion of the pricing kernel in the sense that the agent attaches more weight on low continuation values in recessions. It is this pessimistic behavior that allows our model to explain the asset pricing puzzles.
