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Microeconomic Sources of Equity Risk

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  • Wickens, Michael R

Abstract

Surprisingly there are very few estimates of the equity risk premium period-by-period that satisfy a no-arbitrage condition, despite the vast literature on the subject. This is mainly due to the difficulties of estimation. Using the stochastic discount factor (SDF) model based on observable macroeconomic factors - as opposed to unobservable (latent) affine factors - and a new econometric methodology, we provide new estimates of the equity risk premium for the US and the UK based on monthly data 1975-2001. We obtain estimates of the risk premium for many of the best-known versions of consumption CAPM including time-separable power utility and time-nonseparable Epstein-Zin utility. We also show why many of the formulations of these models are unable to provide estimates of the risk premium. A related, and rapidly growing, literature that adopts a more statistical approach focuses on the empirical relation between the return on equity (or the Sharpe ratio) and return volatility. We argue that SDF theory implies that this relation is misconceived.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4070.

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Date of creation: Sep 2003
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Handle: RePEc:cpr:ceprdp:4070

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Keywords: consumption capm; epstein-zin model; equity risk premium; multivariate garch with no-arbitrage; stochastic discount factor model;

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References

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  1. John Y. Campbell, 1993. "Understanding Risk and Return," NBER Working Papers 4554, National Bureau of Economic Research, Inc.
  2. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 01-90, Wharton School Rodney L. White Center for Financial Research.
  3. Alberto Giovannini & Philippe Weil, 1989. "Risk Aversion and Intertemporal Substitution in the Capital Asset Pricing Model," NBER Working Papers 2824, National Bureau of Economic Research, Inc.
  4. Mike R Wickens & Peter N Smith, . "Macroeconmic Sources of FOREX Risk," Discussion Papers 01/13, Department of Economics, University of York.
  5. Andrew Ang & Monika Piazzesi, 2001. "A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables," NBER Working Papers 8363, National Bureau of Economic Research, Inc.
  6. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
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  8. John T. Scruggs, 1998. "Resolving the Puzzling Intertemporal Relation between the Market Risk Premium and Conditional Market Variance: A Two-Factor Approach," Journal of Finance, American Finance Association, vol. 53(2), pages 575-603, 04.
  9. Smith, Peter & Wickens, Michael, 2002. " Asset Pricing with Observable Stochastic Discount Factors," Journal of Economic Surveys, Wiley Blackwell, vol. 16(3), pages 397-446, July.
  10. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  11. David M Kreps & Evan L Porteus, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Levine's Working Paper Archive 625018000000000009, David K. Levine.
  12. Jarrow, Robert A., 2008. "Operational risk," Journal of Banking & Finance, Elsevier, vol. 32(5), pages 870-879, May.
  13. L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive 1400, David K. Levine.
  14. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  15. Baillie, R.T. & Degennaro, R.P., 1988. "Stock Returns And Volatility," Papers 8803, Michigan State - Econometrics and Economic Theory.
  16. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
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Citations

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Cited by:
  1. Pierre Monnin, . "Are stock markets really like beauty contests? Empirical evidence of higher order belief's impact on asset prices," IEW - Working Papers 202, Institute for Empirical Research in Economics - University of Zurich.
  2. Vit Posta, 2012. "Time-Varying Risk Premium in the Czech Capital Market: Did the Market Experience a Structural Shock in 2008–2009?," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 62(5), pages 450-470, November.
  3. P N Smith & S Sorensen & M R Wickens, 2006. "The Asymmetric Effect of the Business Cycle on the Realtion between Stock Market Returns and their Volatility," Discussion Papers 06/04, Department of Economics, University of York.
  4. P N Smith & S Sorensen & M R Wickens, . "An Asset Market Integration Test Based on Observable Macroeconomic Stochastic Discount Factors," Discussion Papers 03/14, Department of Economics, University of York.
  5. Peter N Smith & Steffen Sorensen & Mike Wickens, 2007. "The Asymmetric Effect of the Business Cycle on the Equity Premium (This is an extensively revised version of earlier paper No. 06/04)," Discussion Papers 07/11, Department of Economics, University of York.
  6. Kocenda, Evzen & Poghosyan, Tigran, 2009. "Macroeconomic sources of foreign exchange risk in new EU members," Journal of Banking & Finance, Elsevier, vol. 33(11), pages 2164-2173, November.
  7. Evžen Koèenda & Tigran Poghosyan, 2010. "Exchange Rate Risk in Central European Countries," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 60(1), pages 22-39, February.
  8. Renatas Kizys & Peter Spencer, 2007. "Assessing the Relation between Equity Risk Premia and Macroeconomic Volatilities," Money Macro and Finance (MMF) Research Group Conference 2006 140, Money Macro and Finance Research Group.

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