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Average debt and equity returns: puzzling?

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  • Ellen R. McGrattan
  • Edward C. Prescott

Abstract

Mehra and Prescott (1985) found the difference between average equity and debt returns puzzling because it was too large to be a premium for bearing nondiversifiable aggregate risk. Here, we re-examine this puzzle, taking into account some factors ignored by Mehra and Prescott-taxes, regulatory constraints, and diversification costs-and focusing on long-term rather than short-term savings instruments. Accounting for these factors, we find the difference between average equity and debt returns during peacetime in the last century is less than 1 percent, with the average real equity return somewhat under 5 percent, and the average real debt return almost 4 percent. As theory predicts, the real return on debt has been close to the 4 percent average after-tax real return on capital. Similarly, as theory predicts, the real return on equity is equal to the after-tax real return on capital plus a modest premium for bearing nondiversifiable aggregate risk.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 313.

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Date of creation: 2003
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Publication status: Published in American Economic Review, Papers and Proceedings (Vol. 93, No. 2, May 2003, pp. 392-397)
Handle: RePEc:fip:fedmsr:313

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  1. S. H. Nerlove, 1932. "Should Life Insurance Companies be Permitted to Buy Common Stocks?," The Journal of Business, University of Chicago Press, vol. 5, pages 155.
  2. Grossman, Sanford J & Shiller, Robert J, 1981. "The Determinants of the Variability of Stock Market Prices," American Economic Review, American Economic Association, vol. 71(2), pages 222-27, May.
  3. Ellen R. McGrattan & Edward C. Prescott, 2005. "Taxes, Regulations, and the Value of U.S. and U.K. Corporations," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 767-796.
  4. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-74, May.
  5. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
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