The Equity Premium: Explained by GDP Growth and Consistent with Portfolio Insurance
AbstractWe find that the long-run equity premium is fully explained by GDP growth and that it is consistent with a short-term portfolio insurance motive. We first derive the macroeconomic equivalent of the standard sustainable growth formula to determine the long-run average return on stocks. The average stock market return depends on the GDP/capita growth rate and the retention rate net of share repurchases. Next, we determine the economy’s return on corporate assets and show that the return on corporate debt is related to overall GDP growth. After calibrating key macro economic/finance parameters, we obtain values for expected equity and corporate debt returns that respectively match the S&P 500 and 3- month T-bill historical arithmetic average returns. Our first conclusion is that in the long-run, the equity premium is generated by economic growth. Our second key result is that the equity premium is also closely approximated by the premium paid on a put option to maintain the value of $1 invested in the market when long-term investors wish to insure against downside risk on a year-to-year basis. These results have implications regarding how risk-free debt is priced and about the economy’s capital structure.
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Bibliographic InfoPaper provided by EconWPA in its series Finance with number 0311004.
Length: 21 pages
Date of creation: 05 Nov 2003
Date of revision:
Note: Type of Document - pdf; prepared on Win2000; to print on HP LaserJet 4 plus; pages: 21; figures: None. Pdf document
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Equity Premium; GDP Growth; Corporate Debt; T-Bills; Risk-Free Rate; Downside Risk; Options; Protective Puts; Portfolio Insurance; Total Stock Return.;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2003-11-09 (All new papers)
- NEP-FMK-2003-11-09 (Financial Markets)
- NEP-MAC-2003-11-09 (Macroeconomics)
- NEP-RMG-2003-11-09 (Risk Management)
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