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The Equity Premium Puzzle and the Ex Post Bias

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Author Info
Jakob B. Madsen (Institute of Economics, University of Copenhagen)

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Abstract

This paper argues that the high historical excess returns to equity are1 a result of a severe ex post bias over the period from 1915 to circa 1960 because inflation surprises during this period drove a wedge between ex ante and ex post returns to bonds. Furthermore, it is shown that ex ante and ex post returns to shares are identical in steady state. Adjusting the ex post equity premium by the ex post bias reduces the equity premium to an arithmetic mean of 3.5-3.9% over the past 130 years.

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Publisher Info
Paper provided by University of Copenhagen. Department of Economics. Finance Research Unit in its series FRU Working Papers with number 2004/01.

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Length: 19 pages
Date of creation: Oct 2004
Date of revision:
Handle: RePEc:kud:kuiefr:200401

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Related research
Keywords: equity premium; inflation expectations; expected returns;

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Find related papers by JEL classification:
G0 - Financial Economics - - General
E1 - Macroeconomics and Monetary Economics - - General Aggregative Models
E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles

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  1. Andrew B. Abel & Olivier J. Blanchard, 1983. "An Intertemporal Model of Saving and Investment," NBER Working Papers 0885, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  2. Madsen, Jakob B, 1998. "General Equilibrium Macroeconomic Models of Unemployment: Can They Explain the Unemployment Path in the OECD?," Economic Journal, Royal Economic Society, vol. 108(448), pages 850-67, May. [Downloadable!] (restricted)
  3. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04. [Downloadable!] (restricted)
    Other versions:
  4. Ellen R. McGrattan & Edward C. Prescott, 2003. "Average Debt and Equity Returns: Puzzling?," American Economic Review, American Economic Association, vol. 93(2), pages 392-397, May. [Downloadable!]
    Other versions:
  5. John Y. Campbell & Tuomo Vuolteenaho, 2004. "Inflation Illusion and Stock Prices," NBER Working Papers 10263, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  6. Perez, Stephen J & Siegler, Mark V, 2003. " Inflationary Expectations and the Fisher Effect prior to World War I," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(6), pages 947-65, December.
  7. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
  8. Barsky, Robert B., 1987. "The Fisher hypothesis and the forecastability and persistence of inflation," Journal of Monetary Economics, Elsevier, vol. 19(1), pages 3-24, January. [Downloadable!] (restricted)
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  9. Olivier J. Blanchard, 1993. "Movements in the Equity Premium," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(1993-2), pages 75-138. [Downloadable!]
  10. Rajnish Mehra & Edward C. Prescott, 2003. "The Equity Premium in Retrospect," NBER Working Papers 9525, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  11. Madsen, Jakob B., 2005. "The Fisher hypothesis and the interaction between share returns, inflation and supply shocks," Journal of International Money and Finance, Elsevier, vol. 24(1), pages 103-120, February. [Downloadable!] (restricted)
  12. Lawrence H. Summers, 1981. "Taxation and Corporate Investment: A q-Theory Approach," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 12(1981-1), pages 67-140. [Downloadable!]
  13. Michael T. Kiley, 2004. "Stock Prices and Fundamentals: A Macroeconomic Perspective," Journal of Business, University of Chicago Press, vol. 77(4), pages 909-936, October. [Downloadable!]
  14. Bhargava, A & Franzini, L & Narendranathan, W, 1982. "Serial Correlation and the Fixed Effects Model," Review of Economic Studies, Blackwell Publishing, vol. 49(4), pages 533-49, October. [Downloadable!] (restricted)
  15. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory And Asset Prices," The Quarterly Journal of Economics, MIT Press, vol. 116(1), pages 1-53, February. [Downloadable!] (restricted)
  16. Barsky, Robert B & De Long, J Bradford, 1991. "Forecasting Pre-World War I Inflation: The Fisher Effect and the Gold Standard," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 815-36, August. [Downloadable!] (restricted)
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