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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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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. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, Econometric Society, vol. 46(1), pages 185-200, January.
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  3. Campbell, John Y, 1996. "Understanding Risk and Return," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(2), pages 298-345, April.
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  6. 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, American Finance Association, vol. 53(2), pages 575-603, 04.
  7. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(4), pages 745-787, May.
  8. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  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. Geert Bekaert & Steven R. Grenadier, 1999. "Stock and Bond Pricing in an Affine Economy," NBER Working Papers 7346, National Bureau of Economic Research, Inc.
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  13. Glosten, Lawrence R & Jagannathan, Ravi & Runkle, David E, 1993. " On the Relation between the Expected Value and the Volatility of the Nominal Excess Return on Stocks," Journal of Finance, American Finance Association, American Finance Association, vol. 48(5), pages 1779-1801, December.
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  16. repec:fth:harver:1421 is not listed on IDEAS
  17. A. Abel, 2010. "Asset prices under habit formation and catching up with the Jones," Levine's Working Paper Archive 1395, David K. Levine.
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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. Peter N Smith & S Sorensen & M R Wickens, 2005. "The asymmetric effect of the business cycle on the relation between stock market returns and their volatility," Money Macro and Finance (MMF) Research Group Conference 2005, Money Macro and Finance Research Group 47, Money Macro and Finance Research Group.
  3. P N Smith & S Sorensen & M R Wickens, . "An Asset Market Integration Test Based on Observable Macroeconomic Stochastic Discount Factors," Discussion Papers, Department of Economics, University of York 03/14, Department of Economics, University of York.
  4. 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, Charles University Prague, Faculty of Social Sciences, vol. 62(5), pages 450-470, November.
  5. Renatas Kizys & Peter Spencer, 2007. "Assessing the Relation between Equity Risk Premia and Macroeconomic Volatilities," Money Macro and Finance (MMF) Research Group Conference 2006, Money Macro and Finance Research Group 140, Money Macro and Finance Research Group.
  6. 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, Department of Economics, University of York 07/11, Department of Economics, University of York.
  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, Charles University Prague, Faculty of Social Sciences, vol. 60(1), pages 22-39, February.
  8. Tigran Poghosyan & Evzen Kocenda, 2007. "Macroeconomic Sources of Foreign Exchange Risk in New EU Members," William Davidson Institute Working Papers Series wp898, William Davidson Institute at the University of Michigan.

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