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Ambiguity and the historical equity premium

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  • Sujoy Mukerji
  • Kevin Sheppard
  • Fabrice Collard and Jean-Marc Tallon

Abstract

This paper assesses the quantitative impact of ambiguity on the historically observed equity premium. We consider a Lucas-tree pure--exchange economy with a single agent where we introduce two key non-standard assumptions. First, the agent's beliefs about the dividend/consumption process is ambiguous, i.e., she is uncertain about the exact probability distribution governing the realization of future dividends and consumption. Second, the agent's preferences are sensitive to this ambiguity, a property formalized using the smooth ambiguity model. The consumption and dividend process is assumed to evolve according to a hidden state model, popularized by Bansal and Yaron (2004), where a persistent latent state variable describes temporary shocks to the mean of consumption growth prospects. We further extend the model to allow for uncertainty about the magnitude of the persistence of the latent state. The agent's beliefs are ambiguous due to the uncertainty about the conditional mean of the probability distribution on consumption and dividends in the next period. We show that in this model ambiguity is endogenously dynamic, for example, increasing during recessions. This results in an endogenously volatile and (counter-)cyclical equity premium. We calibrate the level of ambiguity aversion to match only the first moment of the risk-free rate in data, and ambiguity to match the uncertainty conditional on the historical growth path, and evaluate the model using moderate levels of risk aversion. We find that this simple modification of a Lucas-tree model accounts for a large part of the historical equity premium, both in terms of its level and variation over time.

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Bibliographic Info

Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 550.

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Date of creation: 01 May 2011
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Handle: RePEc:oxf:wpaper:550

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Keywords: Ambiguity aversion; Asset pricing; Equity Premium puzzle;

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  1. Ambiguity and the historical equity premium
    by Christian Zimmermann in NEP-DGE blog on 2011-06-01 14:15:29
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