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Demystifying the Equity Premium

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  • De Santis Massimiliano

    ()
    (NERA Economic Consulting)

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    Abstract

    We provide an explanation for the high equity premium and related puzzles based on persistent dividend growth and idiosyncratic income risk that have previously been shown to have potential for explaining the variance of stock prices, and the low risk-free rate. We show how these two elements can be integrated in a tractable framework to offer a convincing overall account for the history of U.S. asset prices. Our main explanation for the high equity premium is that there is a small persistent component to changes in dividend growth. This component, driven by the "business cycle," makes equity prices very volatile, and hence a poor insurance instrument. The model also explains the extreme volatility of stock prices: the price-dividend ratio predicted by the model based on U.S. consumption data from 1891-2001 has a correlation of 72% with the actual price-dividend ratio in the S&P 500. In addition, we show that a high equity premium is consistent with plausible levels of risk aversion and a low inter-temporal elasticity of substitution, as long as consumption growth is less persistent than income growth.

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    Bibliographic Info

    Article provided by De Gruyter in its journal The B.E. Journal of Macroeconomics.

    Volume (Year): 10 (2010)
    Issue (Month): 1 (May)
    Pages: 1-33

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    Handle: RePEc:bpj:bejmac:v:10:y:2010:i:1:n:11

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    1. Costas Meghir & Luigi Pistaferri, 2004. "Income Variance Dynamics and Heterogeneity," Econometrica, Econometric Society, vol. 72(1), pages 1-32, 01.
    2. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
    3. Alon Brav & George M. Constantinides & Christopher C. Geczy, 1999. "Asset Pricing with Heterogeneous Consumers and Limited Participation: Empirical Evidence," CRSP working papers 505, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    4. Narayana R. Kocherlakota, 1996. "The Equity Premium: It's Still a Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(1), pages 42-71, March.
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    6. Gustavo Grullon & Roni Michaely, 2002. "Dividends, Share Repurchases, and the Substitution Hypothesis," Journal of Finance, American Finance Association, vol. 57(4), pages 1649-1684, 08.
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    9. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    10. Chris I. Telmer, 1991. "Asset Pricing Puzzles and Incomplete Markets," Working Papers 806, Queen's University, Department of Economics.
    11. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2004. "Cyclical Dynamics in Idiosyncratic Labor Market Risk," Journal of Political Economy, University of Chicago Press, vol. 112(3), pages 695-717, June.
    12. Ermini, Luigi, 1991. "Reinterpreting a Temporally Aggregated Consumption CAP Model," Journal of Business & Economic Statistics, American Statistical Association, vol. 9(3), pages 325-28, July.
    13. Tom Krebs, 2004. "Welfare Cost of Business Cycles When Markets Are Incomplete," Working Papers 2004-08, Brown University, Department of Economics.
    14. Cogley, Timothy, 2002. "Idiosyncratic risk and the equity premium: evidence from the consumer expenditure survey," Journal of Monetary Economics, Elsevier, vol. 49(2), pages 309-334, March.
    15. Massimiliano De Santis, 2007. "Individual Consumption Risk and the Welfare Cost of Business Cycles," American Economic Review, American Economic Association, vol. 97(4), pages 1488-1506, September.
    16. Robert E. Hall, 1988. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
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