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Estimating the Equity Premium

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  • Donaldson, R. Glen
  • Kamstra, Mark J.
  • Kramer, Lisa A.

Abstract

Existing empirical research investigating the size of the equity premium has largely consisted of a series of innovations around a common theme: producing a better estimate of the equity premium by using better data or a better estimation technique. The equity premium estimate that emerges from most of this work matches one moment of the data alone: the mean difference between an estimate of the return to holding equity and a risk-free rate. We instead match multiple moments of U.S. market data, exploiting the joint distribution of the dividend yield, return volatility, and realized excess returns, and find that the equity premium lies within 50 basis points of 3.5%, a range much narrower than was achieved in previous studies. Additionally, statistical tests based on the joint distribution of these moments reveal that only those models of the conditional equity premium that embed time variation, breaks, and/or trends are supported by the data. In order to develop the joint distribution of the dividend yield, return volatility, and excess returns, we need a model of price and return fundamentals. We document that even recently developed analytically tractable models that permit autocorrelated dividend growth rates and discount rates impose restrictions that are rejected by the data. We therefore turn to a wider range of models, requiring numerical solution methods and parameter estimation by the simulated method of moments.

Suggested Citation

  • Donaldson, R. Glen & Kamstra, Mark J. & Kramer, Lisa A., 2010. "Estimating the Equity Premium," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(4), pages 813-846, August.
  • Handle: RePEc:cup:jfinqa:v:45:y:2010:i:04:p:813-846_00
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    Cited by:

    1. Kaustia, Markku & Lehtoranta, Antti & Puttonen, Vesa, 2013. "Does sophistication affect long-term return expectations? Evidence from financial advisers' exam scores," SAFE Working Paper Series 3, Leibniz Institute for Financial Research SAFE.
    2. Kuntz, Laura-ChloƩ, 2020. "Beta dispersion and market timing," Journal of Empirical Finance, Elsevier, vol. 59(C), pages 235-256.
    3. Avdis, Efstathios & Wachter, Jessica A., 2017. "Maximum likelihood estimation of the equity premium," Journal of Financial Economics, Elsevier, vol. 125(3), pages 589-609.
    4. Naveed Ul Hassan & Bilal Aziz & Maryam Mushtaq, 2017. "Do Macro-Economic and Technical Indicators Matter?- a Principal Component Analysis Approach for Equity Risk Premium Prediction," European Journal of Economics and Business Studies Articles, European Center for Science Education and Research, vol. 3, EJES Sept.
    5. Kuntz, Laura-ChloƩ, 2020. "Beta dispersion and market timing," Discussion Papers 46/2020, Deutsche Bundesbank.
    6. Efstathios Avdis & Jessica A. Wachter, 2013. "Maximum likelihood estimation of the equity premium," NBER Working Papers 19684, National Bureau of Economic Research, Inc.

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