Determination of asset prices with an investment-specific technology model: Implications for the equity premium puzzle

We explore how the introduction of an investment-specific technology shock and capacity utilization into the dynamic asset-pricing model 'improves' the equity premium and Sharpe ratio. Using the method of undetermined coefficients, we show approximate closed-form analytical solutions for a variety of prices for financial assets. Our main empirical findings show that asset-pricing models with an investment-specific technology shock and capacity utilization perform better than a model with the standard productivity shock and adjustment costs in terms of mimicking the Sharpe ratio and risk premiums of a firm's equity and long-term government bonds. Furthermore, when we introduce habit formation as a special case in our model, the model improves further in terms of replicating the risk premiums of the real economy.