Abstract
The long-term equity premium value is found to both be consistent with historic gross domestic product (GDP) growth and portfolio insurance against downside risk. First, we use a supply-side growth model and demonstrate that the arithmetic average stock market return and the returns on corporate assets and debt all depend on GDP/capita growth. The implied equity premium matches the U.S. historical average over 1926-2001. Alternately, an option-based approach shows that the equity premium is closely approximated by the premium of a put option for insuring a $1 real investment in the stock market against downside risk on a year-to-year basis. A smaller equity premium is predicted by our theory, assuming the recent regime shifts in dividend policies, interest rates, and tax rates are permanent.
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