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Microeconomic Sources of Equity Risk

  • Wickens, Michael R.

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4070.

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Date of creation: Sep 2003
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Handle: RePEc:cpr:ceprdp:4070
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  1. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  2. John T. Scruggs, 1998. "Resolving the Puzzling Intertemporal Relation between the Market Risk Premium and Conditional Market Variance: A Two-Factor Approach," Journal of Finance, American Finance Association, vol. 53(2), pages 575-603, 04.
  3. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  4. Baillie, R.T. & Degennaro, R.P., 1988. "Stock Returns And Volatility," Papers 8803, Michigan State - Econometrics and Economic Theory.
  5. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  6. John Y. Campbell, 1993. "Understanding Risk and Return," NBER Working Papers 4554, National Bureau of Economic Research, Inc.
  7. Smith, Peter & Wickens, Michael, 2002. " Asset Pricing with Observable Stochastic Discount Factors," Journal of Economic Surveys, Wiley Blackwell, vol. 16(3), pages 397-446, July.
  8. repec:fth:harver:1421 is not listed on IDEAS
  9. A. Abel, 2010. "Asset prices under habit formation and catching up with the Jones," Levine's Working Paper Archive 1395, David K. Levine.
  10. Glosten, Lawrence R & Jagannathan, Ravi & Runkle, David E, 1993. " On the Relation between the Expected Value and the Volatility of the Nominal Excess Return on Stocks," Journal of Finance, American Finance Association, vol. 48(5), pages 1779-1801, December.
  11. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, vol. 46(1), pages 185-200, January.
  12. John Y. Campbell, 1985. "Stock Returns and the Term Structure," NBER Working Papers 1626, National Bureau of Economic Research, Inc.
  13. Jarrow, Robert A., 2008. "Operational risk," Journal of Banking & Finance, Elsevier, vol. 32(5), pages 870-879, May.
  14. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
  15. Alberto Giovannini & Philippe Weil, 1989. "Risk Aversion and Intertemporal Substitution in the Capital Asset Pricing Model," NBER Working Papers 2824, National Bureau of Economic Research, Inc.
  16. Geert Bekaert & Steven R. Grenadier, 1999. "Stock and Bond Pricing in an Affine Economy," NBER Working Papers 7346, National Bureau of Economic Research, Inc.
  17. L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive 1400, David K. Levine.
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