Variations in economic uncertainty and risk premiums on capital assets

Abstract

We study the movements in equity prices caused by variation over time in uncertainty about corporate dividends. The framework for our analysis is a general equilibrium model which we fit to NYSE index returns using a method of simulated moments (MSM). Using the model and the MSM estimates, we find that: in general, equity risk premiums are not proportional to return volatility, but are reasonably linear in return variance; equity return volatility is about twice as high as dividend volatility, even though equity prices in our model are rationally determined; dividend-price ratios ‘predict’ subsequent equity returns with about the same precision as found in practice; long-run market returns are negatively autocorrelated; and, consistent with empirical evidence, risk premiums on levered equity are a monotonically increasing function of junk bond yield spreads.