The equity premium

2021 ◽  
pp. 88-102
Author(s):  
Jesper Rangvid
Keyword(s):  
Economic Growth ◽  
Stock Returns ◽  
Risk Premium ◽  
Equity Premium ◽  
Consumption Growth ◽  
Equity Risk ◽  
Bond Returns ◽  
Standard Models ◽  
Premium Puzzle ◽  
Risk Free Rate

This chapter explains ‘the equity premium puzzle’ and ‘the risk-free rate puzzle’. The chapter starts out comparing historical returns on stocks to historical returns on bonds, as well as the risks associated with these returns. The standard models economists use to explain the relative sizes of stock and bond returns, and hence the equity risk premium, are based on the exposure of stocks and bonds to economic growth. The chapter explains why these standard theories fail to explain the size of the equity premium. The chapter also explains how economists have changed their workhorse models to reconcile why returns on stocks are so high compared to bond returns. Another key insight in the chapter is that the equity premium does not depend linearly on economic growth in itself, but on the volatility of economic growth and its correlation with stock returns. Two countries can experience the same level of average economic growth, but different volatilities of consumption growth and correlations between consumption growth and stock returns, causing stock returns to differ between countries. This is one more reason why Chapter 6 finds that economic growth does not line up with stock returns across countries.

Another Look at the Equity Risk Premium Puzzle

2015 ◽  
Vol 16 (4) ◽  
pp. 490-501 ◽  
Author(s):  
Günter Bamberg ◽  
Sebastian Heiden
Keyword(s):  
Risk Aversion ◽  
Financial Markets ◽  
Risk Premium ◽  
Equity Premium ◽  
Equity Risk Premium ◽  
Economic Agents ◽  
Equity Risk ◽  
Pareto Tails ◽  
Return Distributions ◽  
Premium Puzzle

AbstractThe model of Mehra and Prescott (1985, J. Econometrics, 22, 145-161) implies that reasonable coefficients of risk-aversion of economic agents cannot explain the equity risk premium generated by financial markets. This discrepancy is hitherto regarded as a major financial puzzle. We propose an alternative model to explain the equity premium. For normally distributed returns and for returns far away from normality (but still light tailed), realistic equity risk premia do not imply puzzlingly high risk aversions. Following our approach, the ‘equity premium puzzle’ does not exist. We also consider fat-tailed return distributions and show that Pareto tails are incompatible with constant relative risk aversion.

WOULD THERE EVER BE CONSENSUS VALUE AND SOURCE OF THE EQUITY RISK PREMIUM? A REVIEW OF THE EXTANT LITERATURE

2006 ◽  
Vol 09 (02) ◽  
pp. 199-215
Author(s):  
OLUWATOBI OYEFESO
Keyword(s):  
Risk Premium ◽  
Equity Premium ◽  
Unresolved Issue ◽  
Equity Risk Premium ◽  
Equity Premium Puzzle ◽  
Market Risk Premium ◽  
Consensus Value ◽  
Equity Risk ◽  
Premium Puzzle ◽  
The Relationship

This paper reviews the extant studies on the equity premium. While paper attempts to make the review comprehensive, describing all of the work in this area is difficult considering the numerous researches that have been done in this area. Essentially, the paper assesses the relationship between the excess return and the equity risk premium and draws attention to their interchangeable use in the finance literature. Existing literature is reviewed around possible theories explaining the equity premium puzzle and followed by the empirical evidence on the theories. Finally, this paper focuses on the problems of attaining consensus value and source of the market risk premium, which makes equity premium puzzle an unresolved issue among the academics and finance practitioners.

scholarly journals The Fundamental Equity Premium and Ambiguity Aversion in an International Context

Risks ◽  
2018 ◽  
Vol 6 (4) ◽  
pp. 128 ◽  
Author(s):  
Minh Ngo ◽  
Marc Rieger ◽  
Shuonan Yuan
Keyword(s):  
Stock Returns ◽  
Risk Premium ◽  
Ambiguity Aversion ◽  
Equity Premium ◽  
Rate Of Return ◽  
Internal Rate Of Return ◽  
Firm Level ◽  
International Context ◽  
International Data ◽  
Premium Puzzle

Stocks are riskier than bonds. This causes a risk premium for stocks. That the size of this premium, however, seems to be larger than risk aversion alone can explain the so-called “equity premium puzzle”. One possible explanation is the inclusion of a degree of ambiguity in stock returns to account for an additional ambiguity premium, whose size depends on the degree of ambiguity aversion among investors. It is, however, difficult to test this empirically. In this paper, we compute the first firm-level estimation of equity premium based on the internal rate of return (IRR) approach for a total of N = 28,256 companies in 54 countries worldwide. Using a survey of international data on ambiguity aversion, we find a strong and robust relation between equity premia and ambiguity aversion.

scholarly journals Penalized Averaging of Parametric and Non-Parametric Quantile Forecasts

2019 ◽  
Vol 0 (0) ◽  
Author(s):  
Jan G. De Gooijer ◽  
Dawit Zerom
Keyword(s):  
Risk Premium ◽  
Empirical Studies ◽  
Forecast Accuracy ◽  
Equity Premium ◽  
Adaptive Lasso ◽  
Large Set ◽  
Usual Practice ◽  
Conditional Quantile ◽  
Equity Risk ◽  
Non Parametric

Abstract We propose a hybrid penalized averaging for combining parametric and non-parametric quantile forecasts when faced with a large number of predictors. This approach goes beyond the usual practice of combining conditional mean forecasts from parametric time series models with only a few predictors. The hybrid methodology adopts the adaptive LASSO regularization to simultaneously reduce predictor dimension and obtain quantile forecasts. Several recent empirical studies have considered a large set of macroeconomic predictors and technical indicators with the goal of forecasting the S&P 500 equity risk premium. To illustrate the merit of the proposed approach, we extend the mean-based equity premium forecasting into the conditional quantile context. The application offers three main findings. First, combining parametric and non-parametric approaches adds quantile forecast accuracy over and above the constituent methods. Second, a handful of macroeconomic predictors are found to have systematic forecasting power. Third, different predictors are identified as important when considering lower, central and upper quantiles of the equity premium distribution.

Market reaction to scheduled and unscheduled news announcements under varying economic conditions

2020 ◽  
Author(s):  
◽  
Parveshsingh Seeballack
Keyword(s):  
Stock Returns ◽  
Risk Premium ◽  
Implied Volatility ◽  
Equity Market ◽  
Economic Conditions ◽  
Time Varying ◽  
Equity Risk Premium ◽  
Macroeconomic News ◽  
Equity Risk ◽  
News Announcements

The unifying theme of this dissertation is the study of the role of macroeconomic news announcements in the context of the equity market. We focus on two important areas of the asset pricing theory, namely price discovery and equity risk premium forecasting. Chapter 2 investigates the time-varying sensitivity of stock returns to scheduled macroeconomic news announcements (MNAs) using high-frequency data. We present new insights into how efficiently stock returns incorporate the informational content of MNAs. We further provide evidence that the stock market response to MNAs is cyclical, and finally we conclude Chapter 2 with an investigation into the factors driving the time-varying sensitivity of stock return to MNAs. Chapter 3 investigates the time-varying sensitivity of stock returns in the context of unscheduled macroeconomic news announcements using high-frequency data. We investigate the speed and persistence in stock returns’ response to unscheduled macro-news announcements, and whether the reactions are dependent on the state of the economy, or general investor sentiment level. Combined, Chapters 2 and 3 provide interesting insights into how equity market participants react to the arrival of scheduled and unscheduled macro-announcements, under varying economic conditions. Chapter 4 focuses on equity risk premium forecasting. We investigate the predictive ability of option-implied volatility variables at monthly horizon, under varying economic conditions. We innovate by constructing monthly announcement and non-announcement option-implied volatility predictors and assess whether the monthly announcement option-implied volatility predictors contain additional information for better out-of-sample predictions of the monthly equity risk premium. Each of the three empirical chapters explores a unique aspect of the asset pricing theory in the context of the U.S. equity market.

scholarly journals Equity Risk Premium Puzzle: Evidence from Indonesia and Sri Lanka

2019 ◽  
Vol 55 (2) ◽  
pp. 239-248
Author(s):  
Prabath S. Morawakage ◽  
Pulukkuttige D. Nimal ◽  
Duminda Kuruppuarachchi
Keyword(s):  
Sri Lanka ◽  
Risk Premium ◽  
Equity Risk Premium ◽  
Equity Risk ◽  
Premium Puzzle

The Uncertainty Premium in an Ambiguous Economy

2011 ◽  
Vol 01 (02) ◽  
pp. 323-354 ◽  
Author(s):  
Yehuda Izhakian ◽  
Simon Benninga
Keyword(s):  
Risk Aversion ◽  
Risk Premium ◽  
Equity Premium ◽  
Equity Premium Puzzle ◽  
Smooth Model ◽  
Increasing Risk ◽  
Premium Puzzle ◽  
Additional Explanation

The uncertainty premium is the premium that is derived from not knowing the sure outcome (risk premium) and from not knowing the precise odds of outcomes (ambiguity premium). We generalize Pratt's risk premium to uncertainty premium based on Klibanoff et al.'s (2005) smooth model of ambiguity. We show that the uncertainty premium can decrease with an increase in decision maker's risk aversion. This happens because increasing risk aversion always results in a lower ambiguity premium. The positive ambiguity premium may provide an additional explanation to the equity premium puzzle.

Cross Section of KOSPI Returns Based on Cash Flow Risk Factors

2018 ◽  
Vol 26 (3) ◽  
pp. 311-343
Author(s):  
Sungjeh Moon ◽  
Joonhyuk Song
Keyword(s):  
Risk Factors ◽  
Cross Section ◽  
Cash Flow ◽  
Risk Premium ◽  
Flow Model ◽  
Equity Risk Premium ◽  
Consumption Growth ◽  
Equity Risk ◽  
Long Run ◽  
Pricing Error

This paper introduces two risk factors which are the covariance between long-run consumption growth and cash flows and the duration of cash flow, and investigates how these factors serve to explain the KOSPI return risk premiums. Based on our empirical results comparing the proposed two-factor cash flow model with the standard benchmark models such as CAPM and Fama-French 3-factor model (FF-3F), using KOSPI equity including de-listed stocks, the cash flow model explains 74.7% of the cross-section of equity risk premium while CAPM and FF-3F model explains 41.9% and 64.1% to the maximum, respectively, showing that the cash-flow model is superior in explaining the risk premium factor structure compared with the benchmark models. Also, the pricing error is only 4% in the two-factor cash flow model, while CAPM and FF-3F are 7.7% and 4.7%, respectively, indicating the cash flow model outperforms the standard benchmark models in pricing error as well. These results can be interpreted that the cross section of the equity risk premium is related to a firm’s cash flow and long-run consumption, and therefore the growth rate of consumption in the long run rather than contemporaneous consumption growth rate has a greater influence on the determination of the risk premium.

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