A Note on the Interrelation of Volatility Puzzle, Equity Premium Puzzle, and Mean Reversion through State Dependent Preferences

Abstract

According to empirical studies, there is a systematic pattern in the temporal behavior of asset returns and this is related to the business cycle. We propose a simple model that captures this behavior. This model is built around a state dependent preference structure where the state dependency is related to the business cycle. In this setting the volatility puzzle, the equity premium puzzle and mean-reversion appear to be indeed interrelated phenomena. A necessary condition for the three puzzles to be explained is that the state variable is negatively correlated with the market portfolio cum business cycle.