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The Equity Premium: Explained by GDP Growth and Consistent with Portfolio Insurance

Author

Listed:
  • Christophe Faugere

    (U at Albany)

  • Julian Van Erlach

    (Bioscosm Inc.)

Abstract

We find that the long-run equity premium is fully explained by GDP growth and that it is consistent with a short-term portfolio insurance motive. We first derive the macroeconomic equivalent of the standard sustainable growth formula to determine the long-run average return on stocks. The average stock market return depends on the GDP/capita growth rate and the retention rate net of share repurchases. Next, we determine the economy’s return on corporate assets and show that the return on corporate debt is related to overall GDP growth. After calibrating key macro economic/finance parameters, we obtain values for expected equity and corporate debt returns that respectively match the S&P 500 and 3- month T-bill historical arithmetic average returns. Our first conclusion is that in the long-run, the equity premium is generated by economic growth. Our second key result is that the equity premium is also closely approximated by the premium paid on a put option to maintain the value of $1 invested in the market when long-term investors wish to insure against downside risk on a year-to-year basis. These results have implications regarding how risk-free debt is priced and about the economy’s capital structure.

Suggested Citation

  • Christophe Faugere & Julian Van Erlach, 2003. "The Equity Premium: Explained by GDP Growth and Consistent with Portfolio Insurance," Finance 0311004, EconWPA.
  • Handle: RePEc:wpa:wuwpfi:0311004
    Note: Type of Document - pdf; prepared on Win2000; to print on HP LaserJet 4 plus; pages: 21; figures: None. Pdf document
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Eugene F. Fama & Kenneth R. French, 2001. "Disappearing Dividends: Changing Firm Characteristics Or Lower Propensity To Pay?," Journal of Applied Corporate Finance, Morgan Stanley, vol. 14(1), pages 67-79.
    3. Arturo Estrella & Jeffrey C. Fuhrer, 1983. "Average Marginal Tax Rates U.S. Household Interest and Dividend Income 1954-80," NBER Working Papers 1201, National Bureau of Economic Research, Inc.
    4. Scholes, Myron, 1976. "Taxes and the Pricing of Options," Journal of Finance, American Finance Association, vol. 31(2), pages 319-332, May.
    5. Brennan, Michael J & Schwartz, Eduardo S, 1989. "Portfolio Insurance and Financial Market Equilibrium," The Journal of Business, University of Chicago Press, vol. 62(4), pages 455-472, October.
    6. Leland, Hayne E, 1980. " Who Should Buy Portfolio Insurance?," Journal of Finance, American Finance Association, vol. 35(2), pages 581-594, May.
    7. Rubinstein, Mark, 1984. " A Simple Formula for the Expected Rate of Return of an Option over a Finite Holding Period," Journal of Finance, American Finance Association, vol. 39(5), pages 1503-1509, December.
    8. Mordecai Kurz & Andrea Beltratti, "undated". "The Equity Premium is No Puzzle," Working Papers 96004, Stanford University, Department of Economics.
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    12. Merton, Robert C & Scholes, Myron S & Gladstein, Mathew L, 1982. "The Returns and Risks of Alternative Put-Option Portfolio Investment Strategies," The Journal of Business, University of Chicago Press, vol. 55(1), pages 1-55, January.
    13. Ellen R. McGrattan & Edward C. Prescott, 2001. "Taxes, Regulations, and Asset Prices," NBER Working Papers 8623, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Casper Christophersen & Petr Jakubik, 2014. "Insurance and the Macroeconomic Environment," EIOPA Financial Stability Report - Thematic Articles 1, EIOPA, Risks and Financial Stability Department.

    More about this item

    Keywords

    Equity Premium; GDP Growth; Corporate Debt; T-Bills; Risk-Free Rate; Downside Risk; Options; Protective Puts; Portfolio Insurance; Total Stock Return.;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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