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The size of the equity premium

  • Fabio Fornari


    (Banca d�Italia, Economic Research Department)

Among the many controversial variables in finance, risk premia stand out for their lack of observability. Measuring premia as the difference between realized returns on risky and risk-free assets has not led to unanimous conclusions about their size, which greatly depends on the length of the sample; in addition, investment allocations or inflation expectations are influenced by the ex-ante values of the risk premia and ex-post returns are, if any, rough approximations of these. Many papers have dealt with this issue, from the initial contribution of Mehra and Prescott (1985) to very recent advances within a bayesian framework of P�stor and Stambaugh (2001). This paper uses conditional variance models as approximations of static and intertemporal capital asset pricing models; the size of the equity premium is assessed for the US both at the market level and, through a conditional version of the three-factor model of Fama and French (1993), at a firm-level. The market premium has had large swings with short-lived peaks over the last 75 years, fluctuating around a mean value of 5 per cent on a yearly basis; this value rises to 6.5 percent when time-varying investment opportunities are allowed for. In periods of economic expansion the expected premium on the equity return is nearly half the value expected in recession, 20 percent less if the Great Depression period is excluded; the cross-sectional dispersion of the firm-level premia as a function of firm�s size is also influenced by the position of the economy within the business cycle.

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Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 447.

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Date of creation: Jul 2002
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Handle: RePEc:bdi:wptemi:td_447_02
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  1. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  2. Luboš Pástor & Robert F. Stambaugh, 2000. "The Equity Premium and Structural Breaks," CRSP working papers 519, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  3. Engle, Robert F. & Ng, Victor K. & Rothschild, Michael, 1990. "Asset pricing with a factor-arch covariance structure : Empirical estimates for treasury bills," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 213-237.
  4. Merton, Robert C., 1980. "On estimating the expected return on the market : An exploratory investigation," Journal of Financial Economics, Elsevier, vol. 8(4), pages 323-361, December.
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  8. Backus, David K & Gregory, Allan W, 1993. "Theoretical Relations between Risk Premiums and Conditional Variances," Journal of Business & Economic Statistics, American Statistical Association, vol. 11(2), pages 177-85, April.
  9. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
  10. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
  11. Louis K.C. Chan & Jason Karceski & Josef Lakonishok, 2001. "The Level and Persistence of Growth Rates," NBER Working Papers 8282, National Bureau of Economic Research, Inc.
  12. Christopher M. Turner & Richard Startz & Charles R. Nelson, 1989. "A Markov Model of Heteroskedasticity, Risk, and Learning in the Stock Market," NBER Working Papers 2818, National Bureau of Economic Research, Inc.
  13. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  14. Harvey, Campbell R., 1989. "Time-varying conditional covariances in tests of asset pricing models," Journal of Financial Economics, Elsevier, vol. 24(2), pages 289-317.
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  16. John R. Graham & Campbell R. Harvey, 2001. "Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance Perspective," NBER Working Papers 8678, National Bureau of Economic Research, Inc.
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