High Equity Premia and Crash Fears. Rational Foundations

We show that when in Lucas trees model the process for dividends is described by a lattice tree subject to infrequent but observable structural breaks, in equilibrium recursive rational learning may inßate the equity risk premium and reduce the risk-free interest rate for low levels of risk aversion. The key condition for these results to obtain is the presence of sufficient initial pessimism. The relevance of these Þndings is magniÞed by the fact that under full information our artiÞcial economy cannot generate asset returns matching the empirical evidence for any positive relative risk aversion. JEL codes: G12, D83.