A simple explanation of three Financial Economics Puzzles
Martin Weitzman has an excellent piece in the Sept. 07 American Economic Review that provides exactly that. He argues that papers using a Rational Expectations Equilibrium (REE) approach generate the equity premium puzzle (it's too big), the risk free rate puzzle (it's too low) and the equity volatility puzzle (it's too volatile compared to fundamentals), by incorrectly assuming that the underlying density generating growth shocks is known to agents. Simply replacing the known variance with an estimated variance (changing the normal density to a student-t density) can actually REVERSE the puzzles.
Maybe I should let him tell it:
"Intuitively, a normal density becomes a Student-t from a tail-thickening spreading-apart of probabilities caused by the variance of the normal having itself a (inverted gamma) probability distribution. There is then no surprise from expected utility theory that people are more averse qualitatively to a relatively thick-tailed Student-t child distribution than they are to the relatively thin-tailed normal parent which begets it. A much more surprising consequence of expected utility theory is the quantitative strength of this endogenously-derived aversion to the effects of unknown variance-structure. The story behind this quantitative strength is that thickened posterior left tails represent structural uncertainty about rare disasters that terrify people. This fear-factor effect holds for any utility function having everywhere-positive relative risk aversion."
So fear of rare events whose generating distributions are not known can cause the puzzles we see without any excessive amount of risk aversion by agents. I think this is a very nice and important paper.