A model of mean reversion in stock prices and the Equity Premium Puzzle

Mapping Intimacies ◽

10.31219/osf.io/6gwjq ◽

2019 ◽

Author(s):

Yuuki Maruyama

Keyword(s):

Stock Prices ◽

Stock Price ◽

Equity Premium ◽

Risk Preference ◽

Equity Premium Puzzle ◽

Fundamental Value ◽

Premium Puzzle ◽

Short Term Investment ◽

Current Risk

In this model, the stock price is determined by two variables: the fundamental value and the current risk preference of people. Suppose that the fundamental value follows Geometric Brownian motion and the function of the risk preference of people follows Ornstein-Uhlenbeck process. There are only two types of asset: money (safe asset) and stocks (risk asset). In this case, the profit rate of equity investment is mean reverting, and long-term investment is more advantageous than short-term investment. The market is arbitrage-free. Also, based on this model, I suggest a solution to the Equity Premium Puzzle.

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Macroeconomic Factors and Pakistani Equity Market”

The Pakistan Development Review ◽

10.30541/v43i4iipp.619-637 ◽

2004 ◽

Vol 43 (4II) ◽

pp. 619-637 ◽

Cited By ~ 11

Author(s):

Muhammad Nishat ◽

Rozina Shaheen

Keyword(s):

Stock Market ◽

Industrial Production ◽

Stock Prices ◽

Stock Price ◽

Consumer Price Index ◽

Reverse Causality ◽

Macroeconomic Factors ◽

Macroeconomic Variables ◽

Equilibrium Relationships

This paper analyzes long-term equilibrium relationships between a group of macroeconomic variables and the Karachi Stock Exchange Index. The macroeconomic variables are represented by the industrial production index, the consumer price index, M1, and the value of an investment earning the money market rate. We employ a vector error correction model to explore such relationships during 1973:1 to 2004:4. We found that these five variables are cointegrated and two long-term equilibrium relationships exist among these variables. Our results indicated a "causal" relationship between the stock market and the economy. Analysis of our results indicates that industrial production is the largest positive determinant of Pakistani stock prices, while inflation is the largest negative determinant of stock prices in Pakistan. We found that while macroeconomic variables Granger-caused stock price movements, the reverse causality was observed in case of industrial production and stock prices. Furthermore, we found that statistically significant lag lengths between fluctuations in the stock market and changes in the real economy are relatively short.

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