1 Balduzzi is from the Carroll School of Management, Boston College. Kallal is from Salomon Brothers. We thank Giorgio De Santis, John Heaton, Silverio Foresi, Ravi Jagannathan, Peter Knez, Anthony Lynch, Margaret McMillan, Ken Singleton, René Stulz, two anonymous referees, and seminar participants a · 2 Balduzzi is from the Carroll School of Management, Boston College. Kallal is from Salomon Brothers. We thank Giorgio De Santis, John Heaton, Silverio Foresi, Ravi Jagannathan, Peter Knez, Anthony Lynch, Margaret McMillan, Ken Singleton, René Stulz, two anonymous referees, and seminar participants at
Abstract
If a pricing kernel assigns a premium to a risk variable that differs from the one assigned by the minimum-variance admissible kernel, then the pricing kernel must exhibit more variability than the minimum-variance kernel. Based on this intuition, we derive a variance bound that is more stringent than that of Hansen and Jagannathan (1991). When we apply our bound to the kernel of a representative consumer with power utility, we find that the consumption risk premium increases the severity of the “equity-premium puzzle” of Mehra and Prescott (1985).