The best known empirical failures of consumption-based asset pricing models are the equity premium puzzle and the risk-free rate puzzle. Mehra and Prescott (1985) investigate U.S. data from 1889 to 1978 and find that the mean annual premium of equity return over the riskless rate was around 6% which is too large to be justified by the standard Arrow-Debreu model with a plausible degree of risk aversion. In other words, stocks are not sufficiently riskier than Treasury bills to explain the spread in their returns.
This is the well-known equity premium puzzle. In the same paper, Mehra and Prescott point out that the real interest rate of 0.8%, which was too low to be explicable in their model. Weil (1989) terms the low interest rate as a puzzle because it cannot be justified by his representative agent model with a plausible degree of risk aversion and an arbitrary level of inter-temporal elasticity of substitution. These asset pricing puzzles represent large gaps in our understanding of macroeconomy (see Kockerlakota 1996).
In this paper, we show that asset pricing puzzles are closely related to the capital structure puzzle (i.e. how does a firm determine its debt-to-capital ratio? see Myers, 1984). First, a solution to asset pricing puzzles requires a good understanding of how a firm determines its capital structure, because a firm’s bond issuing affects the dividend flow of its stocks and consequently stock prices. That is, we need to take into account the firm’s behavior other than consumers’ behavior.
Second, a solution to the capital structure puzzle demands a good framework of asset pricing. The motivation of our solution to the capital structure puzzle is based on an identity: a firm’s debt-to-equity ratio is identical with the ratio of the aggregate value of bonds held by consumers to the firm’s stock value. We argue that the capital structure is determined by shareholders and bondholders (rather than by the management). Thus, an asset pricing framework without the equity premium puzzle or the risk-free rate puzzle could yield a correct debt-to-equity ratio.
We resolve the three puzzles by examining a consumption-based asset pricing model with three ingredients: (i) the life cycle, (ii) a borrowing constraint, and (iii) a majority decision rule on capital structure. The first two ingredients help to account for the risk-free rate puzzle. The third ingredient ensures that a firm’s debt-to-capital ratio is endogenously determined by risk-averse shareholders and that a proper financial leverage is used to generate a high stock return. As a result, the model yields a high equity premium.
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A Resolution to Equity Premium Puzzle, Risk-Free Rate Puzzle, and Capital Structure Puzzle
