Abstract
Stocks are riskier than bonds. This causes a risk premium for stocks. That the size of this premium, however, seems to be larger than risk aversion alone can explain the so-called “equity premium puzzle”. One possible explanation is the inclusion of a degree of ambiguity in stock returns to account for an additional ambiguity premium, whose size depends on the degree of ambiguity aversion among investors. It is, however, difficult to test this empirically. In this paper, we compute the first firm-level estimation of equity premium based on the internal rate of return (IRR) approach for a total of N = 28,256 companies in 54 countries worldwide. Using a survey of international data on ambiguity aversion, we find a strong and robust relation between equity premia and ambiguity aversion.
Highlights
The equity risk premium puzzle is one of the classic puzzles in finance
We study in this paper the impact of these cultural dimensions, together with ambiguity aversion on the equity premium with the aim to shed some new light on this potential connection
As indicated in Gollier (2011): if the distribution of the returns of the equity market is ambiguous and agents bias their beliefs towards the one with the smallest expected utility, i.e., ambiguity aversion, the sufficient conditions for an increase in ambiguity aversion to reduce the demand for the risky asset, i.e., an increase in the equity premium, are the following: (1) the marginals can be ranked by first-order stochastic dominance, and relative risk aversion is less than unity; (2) the marginals can be ranked by Rothschild and Stiglitz’s increase in risk, and relative prudence is positive and less than two; and (3) the marginals can be ranked by second-order stochastic dominance and central dominance
Summary
The equity risk premium puzzle is one of the classic puzzles in finance. Going back nearly three decades, Mehra and Prescott (1985) found that historical average returns on equity on the U.S stock market from 1889 to 1978 (90 years) far exceeded the average returns of short-term debt, corresponding to basically riskless assets. Ambiguity aversion is crucial for this effect It has been modeled as an additional behavioral factor beyond risk aversion to contribute to the equity premium (Abel (1989); Abel (2002); Chen and Epstein (2003); Klibanoff et al (2005); Barillas et al (2009); Gollier (2011); Ju and Miao (2012)). There is not yet a solid model linking cultural factors to market anomalies, but only some empirical evidence from international research, such as overconfidence momentum returns (Chui et al (2010)), risk attitudes and the value premium (Chui et al (2012); Caliskan and Hens (2017)) , as well as uncertainty avoidance and the equity premium (Rieger and Wang (2012)).
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