'The Equity Premium and the Risk Free Rate: Matching the Moments,'Journal of Monetary Economics 31 (February 1993) 21-46(with P.-s. Lam and N. Mark).

This paper investigates the ability of a representative agent model with time separable utility to explain the mean vector and the covariance matrix of the risk-free interest rate and the return to equity. We generalize the standard calibration methodology by accounting for the uncertainty in both the sample moments to be explained and the estimated parameters to which the model is calibrated, and then develop a testing framework to evaluate the model's ability to match the moments of the data. We study a model in which dividends explicitly represent the flow that accrues to the owner of the equity, and they are discounted by the intertemporal marginal rate of substitution defined over consumption. We find that the first moments of the data can be matched for a wide range of preference parameter values, the model's implied first and second moments taken together are always statistically significantly different from the data at standard levels. This last result contrasts sharply with recent treatments of leverage in the literature.