Crash states and the equity premium: Solving one puzzle raises another

This paper examines the behavior of asset returns as predicted by the consumption-based capital asset pricing model within an artificial economy that includes a low probability, crash state in consumption and dividends. It is demonstrated that the behavior of agents' intertemporal marginal rate of substitution in such an economy is consistent with the Hansen and Jagannathan (1991) frontier even though the consumption process in the model is calibrated to actual data, preferences are time separable, and agents' relative risk aversion is restricted to moderate levels. Moreover, as demonstrated by Rietz (1988), the crash-state economy can replicate the mean of excess returns on equity, i.e. the equity premium. However, the model severely underpredicts the volatility of excess returns. (C) 1998 Elsevier Science B.V. All rights reserved.