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Microeconomic Sources of Equity Risk

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  • Wickens, Michael R.

Abstract

Surprisingly there are very few estimates of the equity risk premium period-by-period that satisfy a no-arbitrage condition, despite the vast literature on the subject. This is mainly due to the difficulties of estimation. Using the stochastic discount factor (SDF) model based on observable macroeconomic factors - as opposed to unobservable (latent) affine factors - and a new econometric methodology, we provide new estimates of the equity risk premium for the US and the UK based on monthly data 1975-2001. We obtain estimates of the risk premium for many of the best-known versions of consumption CAPM including time-separable power utility and time-nonseparable Epstein-Zin utility. We also show why many of the formulations of these models are unable to provide estimates of the risk premium. A related, and rapidly growing, literature that adopts a more statistical approach focuses on the empirical relation between the return on equity (or the Sharpe ratio) and return volatility. We argue that SDF theory implies that this relation is misconceived.

Suggested Citation

  • Wickens, Michael R., 2003. "Microeconomic Sources of Equity Risk," CEPR Discussion Papers 4070, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:4070
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    Cited by:

    1. Renatas Kizys & Peter Spencer, 2007. "Assessing the Relation between Equity Risk Premium and Macroeconomic Volatilities in the UK," Discussion Papers 07/13, Department of Economics, University of York.
    2. Ioannis N. Kallianiotis, 2016. "Factors Affecting the Exchange Rate Risk Premium," Journal of Applied Finance & Banking, SCIENPRESS Ltd, vol. 6(6), pages 1-3.
    3. Pierre Monnin, "undated". "Are stock markets really like beauty contests? Empirical evidence of higher order belief's impact on asset prices," IEW - Working Papers 202, Institute for Empirical Research in Economics - University of Zurich.
    4. Renatas Kizys & Peter Spencer, 2007. "Assessing the Relation between Equity Risk Premia and Macroeconomic Volatilities," Money Macro and Finance (MMF) Research Group Conference 2006 140, Money Macro and Finance Research Group.
    5. Evžen Koèenda & Tigran Poghosyan, 2010. "Exchange Rate Risk in Central European Countries," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 60(1), pages 22-39, February.
    6. Peter N Smith & Steffen Sorensen & Mike Wickens, 2007. "The Asymmetric Effect of the Business Cycle on the Equity Premium (This is an extensively revised version of earlier paper No. 06/04)," Discussion Papers 07/11, Department of Economics, University of York.
    7. P N Smith & S Sorensen & M R Wickens, "undated". "An Asset Market Integration Test Based on Observable Macroeconomic Stochastic Discount Factors," Discussion Papers 03/14, Department of Economics, University of York.
    8. Peter N Smith & S Sorensen & M R Wickens, 2005. "The asymmetric effect of the business cycle on the relation between stock market returns and their volatility," Money Macro and Finance (MMF) Research Group Conference 2005 47, Money Macro and Finance Research Group.
    9. Vit Posta, 2012. "Time-Varying Risk Premium in the Czech Capital Market: Did the Market Experience a Structural Shock in 2008–2009?," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 62(5), pages 450-470, November.
    10. Bernard Walley, 2015. "Macroeconomic sources of foreign exchange risk premium: evidence from South Africa," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 39(2), pages 382-395, April.
    11. Kocenda, Evzen & Poghosyan, Tigran, 2009. "Macroeconomic sources of foreign exchange risk in new EU members," Journal of Banking & Finance, Elsevier, vol. 33(11), pages 2164-2173, November.
    12. Ioannis N. Kallianiotis, 2022. "Trade Balance and Exchange Rate: The J-Curve," Journal of Applied Finance & Banking, SCIENPRESS Ltd, vol. 12(2), pages 1-3.

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    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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