The size of the equity premium
AbstractAmong the many controversial variables in finance, risk premia stand out for their lack of observability. Measuring premia as the difference between realized returns on risky and risk-free assets has not led to unanimous conclusions about their size, which greatly depends on the length of the sample; in addition, investment allocations or inflation expectations are influenced by the ex-ante values of the risk premia and ex-post returns are, if any, rough approximations of these. Many papers have dealt with this issue, from the initial contribution of Mehra and Prescott (1985) to very recent advances within a bayesian framework of PÃ¡stor and Stambaugh (2001). This paper uses conditional variance models as approximations of static and intertemporal capital asset pricing models; the size of the equity premium is assessed for the US both at the market level and, through a conditional version of the three-factor model of Fama and French (1993), at a firm-level. The market premium has had large swings with short-lived peaks over the last 75 years, fluctuating around a mean value of 5 per cent on a yearly basis; this value rises to 6.5 percent when time-varying investment opportunities are allowed for. In periods of economic expansion the expected premium on the equity return is nearly half the value expected in recession, 20 percent less if the Great Depression period is excluded; the cross-sectional dispersion of the firm-level premia as a function of firmÂ’s size is also influenced by the position of the economy within the business cycle.
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Bibliographic InfoPaper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 447.
Date of creation: Jul 2002
Date of revision:
equity premium; garch;
Find related papers by JEL classification:
- C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models &bull Diffusion Processes
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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