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Maximum likelihood estimation of the equity premium

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  • Efstathios Avdis
  • Jessica A. Wachter

Abstract

The equity premium, namely the expected return on the aggregate stock market less the government bill rate, is of central importance to the portfolio allocation of individuals, to the investment decisions of firms, and to model calibration and testing. This quantity is usually estimated from the sample average excess return. We propose an alternative estimator, based on maximum likelihood, that takes into account information contained in dividends and prices. Applied to the postwar sample, our method leads to an economically significant reduction from 6.4% to 5.1%. Simulation results show that our method produces tighter estimates under a range of specifications.

Suggested Citation

  • Efstathios Avdis & Jessica A. Wachter, 2013. "Maximum likelihood estimation of the equity premium," NBER Working Papers 19684, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:19684
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    References listed on IDEAS

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    More about this item

    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
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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