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An Anatomy of the Equity Premium

Author

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  • Paul Schneider

    (University of Lugano, EPFL, Swiss Finance Institute, and Boston University)

Abstract

This paper introduces a decomposition of the market return in terms of higher-order realized, and option-implied risk aversion, connecting it to level, slope, and curvature of the implied volatility surface. Empirically, second-order risk aversion -- loss aversion -- explains most of the market return. Signals revealed by this risk anatomy provide predictive power out-of-sample for realized returns in particular for longer maturities. The decomposition also shows that compensation for disaster risk is not prominently featured in the market return. Furthermore it highlights that models with identically and independently distributed state variables are not suited to represent in particular longer-maturity returns.

Suggested Citation

  • Paul Schneider, 2015. "An Anatomy of the Equity Premium," Swiss Finance Institute Research Paper Series 15-61, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp1561
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    File URL: http://ssrn.com/abstract=2677698
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    More about this item

    Keywords

    equity premium; model-free; risk aversion; skewness;
    All these keywords.

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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