How to profit from mean reverting risk premiums? Implications for stock selection

Abstract

This paper investigates the behaviour of risk premiums of European stocks. It is found that risk premiums deviate significantly from their equilibrium level. Over time, however, they revert to their equilibrium level. This reversion can be exploited in an active stock selection strategy. Compared with a passive investment, such a strategy yields a risk adjusted excess return of more than 8 per cent p.a. for a medium level of risk (ie 6 per cent tracking error).