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Average Debt and Equity Returns: Puzzling?

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  • Ellen R. McGrattan
  • Edward C. Prescott

Abstract

Mehra and Prescott (1985) found the difference between average equity and debt returns puzzling because it was too large to be a premium for bearing nondiversifiable aggregate risk. Here, we re-examine this puzzle, taking into account some factors ignored by Mehra and Prescott-taxes, regulatory constraints, and diversification costs-and focusing on long-term rather than short-term savings instruments. Accounting for these factors, we find the difference between average equity and debt returns during peacetime in the last century is less than 1 percent, with the average real equity return somewhat under 5 percent, and the average real debt return almost 4 percent. As theory predicts, the real return on debt has been close to the 4 percent average after-tax real return on capital. Similarly, as theory predicts, the real return on equity is equal to the after-tax real return on capital plus a modest premium for bearing nondiversifiable aggregate risk.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/000282803321947407
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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 93 (2003)
Issue (Month): 2 (May)
Pages: 392-397

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Handle: RePEc:aea:aecrev:v:93:y:2003:i:2:p:392-397

Note: DOI: 10.1257/000282803321947407
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  1. Sanford J. Grossman & Robert J. Shiller, 1980. "The Determinants of the Variability of Stock Market Prices," NBER Working Papers 0564, National Bureau of Economic Research, Inc.
  2. S. H. Nerlove, 1932. "Should Life Insurance Companies be Permitted to Buy Common Stocks?," The Journal of Business, University of Chicago Press, vol. 5, pages 155.
  3. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  4. Ellen R. McGrattan & Edward C. Prescott, 2005. "Taxes, regulations, and the value of U.S. and U.K. corporations," Staff Report 309, Federal Reserve Bank of Minneapolis.
  5. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-74, May.
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