Risk Premia on Equity and Debt in a DSGE Model with Long-Run Real and Nominal Risks

The risk premium on equities and nominal and real long-term debt in the standard dynamic stochastic general equilibrium (DSGE) model used in macroeconomics is far too small and stable relative to empirical measures obtained from the data--an example of the equity and bond "premium puzzles." However, in models of endowment economies, researchers have been able to generate reasonable risk premiums by assuming that investors have recursive Epstein-Zin preferences and face long-run economic risks. We show that introducing Epstein-Zin preferences into a canonical DSGE model can also produce large and variable risk premiums on these securities without compromising the model's ability to …fit key macroeconomic variables. Long-run real and nominal risks further improve the model's ability to fi…t the data with a lower level of household risk aversion.