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The Equity Premium: Explained by GDP Growth and Consistent with Portfolio Insurance

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Author Info

  • Christophe Faugere

    (U at Albany)

  • Julian Van Erlach

    (Bioscosm Inc.)

Abstract

We 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 Info

Paper provided by EconWPA in its series Finance with number 0311004.

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Length: 21 pages
Date of creation: 05 Nov 2003
Date of revision:
Handle: RePEc:wpa:wuwpfi:0311004

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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Web page: http://128.118.178.162

Related research

Keywords: Equity Premium; GDP Growth; Corporate Debt; T-Bills; Risk-Free Rate; Downside Risk; Options; Protective Puts; Portfolio Insurance; Total Stock Return.;

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References

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  1. Hayne E. Leland., 1979. "Who Should Buy Portfolio Insurance?," Research Program in Finance Working Papers 95, University of California at Berkeley.
  2. Brennan, Michael J & Schwartz, Eduardo S, 1989. "Portfolio Insurance and Financial Market Equilibrium," The Journal of Business, University of Chicago Press, vol. 62(4), pages 455-72, October.
  3. Merton, Robert C & Scholes, Myron S & Gladstein, Mathew L, 1982. "The Returns and Risks of Alternative Put-Option Portfolio Investment Strategies," The Journal of Business, University of Chicago Press, vol. 55(1), pages 1-55, January.
  4. Arturo Estrella & Jeffrey C. Fuhrer, 1983. "Average Marginal Tax Rates U.S. Household Interest and Dividend Income 1954-80," NBER Working Papers 1201, National Bureau of Economic Research, Inc.
  5. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
  6. Ellen R. McGrattan & Edward C. Prescott, 2001. "Taxes, regulations, and asset prices," Working Papers 610, Federal Reserve Bank of Minneapolis.
  7. Ellen R. McGrattan & Edward C. Prescott, 2000. "Is the stock market overvalued?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40.
  8. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04.
  9. Fama, Eugene F. & French, Kenneth R., 2001. "Disappearing dividends: changing firm characteristics or lower propensity to pay?," Journal of Financial Economics, Elsevier, vol. 60(1), pages 3-43, April.
  10. Roger G. Ibbotson & Peng Chen, 2003. "Long-Run Stock Returns: Participating in the Real Economy," Yale School of Management Working Papers ysm354, Yale School of Management.
  11. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  12. Rubinstein, Mark, 1984. " A Simple Formula for the Expected Rate of Return of an Option over a Finite Holding Period," Journal of Finance, American Finance Association, vol. 39(5), pages 1503-09, December.
  13. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  14. Scholes, Myron, 1976. "Taxes and the Pricing of Options," Journal of Finance, American Finance Association, vol. 31(2), pages 319-32, May.
  15. Kurz, M. & Beltratti, A., 1996. "The Equity Premium Is No Puzzle," Papers 282, Banca Italia - Servizio di Studi.
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