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On the Time Variation of the Market Risk Premium

Motivated by the empirical observation that there exists some degree of predictability in asset returns, this paper investigates the theoretical constraints on the time variation in the risk premia of the market portfolio in a continuous-time, finite horizon pure exchange economy. By characterizing the equilibrium conditions as nonlinear partial differential equations, closed-form solutions can be obtained. It is shown that in a stationary economy, the presence of intermediate consumption can have a drastic effect on the possible kinds of time-varying behaviour of the risk premia.