Equity Premium Research Articles

Asset prices when large investors interact strategically

This paper examines equilibrium asset prices and leverage in an exchange economy populated with both retail and institutional investors. Institutional investors influence the price of the stocks they trade and are aware of the price impact of the opponent and, thus, interact strategically. Because of the price impact, institutional investors decrease their demand for stocks and lend money to the retail sector, thereby increasing leverage in the economy. The risk-free rate (equity premium) tends to be lower (higher) as compared to an economy populated by retail investors only. Retail investors' compensation for liquidity provision depends on the behavior of institutional investors and the state of the economy.

On the sources of the aggregate risk premium: Risk aversion, bubbles or regime-switching?

We develop and estimate a consumption-based asset pricing model that uses historical US financial data and assumes recursive utility, allowing for priced regime-switching risk and intrinsic bubbles. We also estimate several restricted versions, including only a subset of these features. Priced regime-switching risk is essential to the equity risk premium, explaining more than fifty per cent of it. Furthermore, a model that does not consider regime switching would overestimate the public's risk aversion, mistakenly assigning the observed risk premium to high-risk aversion instead of priced regime-switching. We also find that intrinsic bubbles are statistically significant, and even though they are not crucial in explaining the risk premium, they substantially improve the model's fit at the end of the sample.

The impact of the Bank of Japan’s exchange traded fund and corporate bond purchases on firms’ capital structure

AbstractThis study examines how the Bank of Japan’s (BOJ’s) exchange-traded fund (ETF) and corporate bond (CB) purchases affect the capital structure of Japanese listed firms. The results first suggest that the BOJ’s ETF purchases reduced the equity risk premium for firms included in the purchases, thereby lowering their cost of equity. These firms issued more stocks and became less dependent on bond debt and bank loans than control firms, resulting in a lower level of leverage. On the other hand, the BOJ’s CB purchases lowered the risk premium of bonds eligible for such purchases, which implies a decline in the cost of bond debt. Firms eligible for CB purchases issued more bonds, while reducing bank debt but to a smaller extent, thus having higher leverage than firms not eligible for CB purchases. Categorizing firms into four groups based on whether their stocks were included in ETF purchases and/or their bonds were eligible for CB purchases further shows that the policy impacts on firm financing have differed depending on which group a firm fell in. These results indicate that the BOJ’s ETF and CB purchases have had a considerable impact on the cost of capital, securities issuance activities, and corporate capital structure.

Disaster learning and aggregate investment

We extend a production-based asset pricing model by introducing learning about disaster risk. The information is not perfect, and Bayesian learning is adopted to update beliefs about the likelihood of rare disasters. We show that disaster learning reconciles key stylized facts about macroeconomic quantities and financial markets. For macroeconomic quantities, during the crisis, the decline in aggregate investments is much worse than that of output, whereas the decline in aggregate consumption is moderate relative to that of output. Additionally, the model endogenously features lower consumption volatility and higher investment volatility than that of output. For financial markets, belief updating over a rare disaster produces a higher equity premium, lower risk-free rate, and more volatile stock returns. Finally, we show that jump intensity uncertainty accounts for a substantial fraction of the total welfare cost of rare disasters.

The Predictive Power of Capital Asset Pricing Model and Consumption Capital Asset Pricing Model in Nigeria

The examination of the predictive power of CAPM and CCAPM in determining risk premium in Nigeria between 1999-2014 shows that CAPM is statistically significant for all equities although the coefficient is relatively high. However, CCAPM was statistically not significant for all equities listed though the results was meaningful. This is in line with the findings of Mankiw and Shapiro (1986), Chen (2003) and Idolor (2012) where the authors’ findings did not support CCAPM but concluded that the superiority of CAPM is a puzzle. In conclusion Capital Asset Pricing Model produced a more meaningful and statistically significant result in predicting equity premium in Nigeria than Consumption Capital Asset Pricing Model.

Risks to Human Capital

We build a model with inalienable human capital, in which investors finance individuals who can potentially become skilled. Although investment in skill is always optimal, it does not take place in some states of the world, due to moral hazard. In intermediate states of the world, individuals acquire skill; however outside investors and individuals inefficiently share risk. We show that this simple moral hazard problem, combined with risk aversion of individuals and outside investors, amplifies the equity premium, lowers the risk-free rate, and leads to disaster states that fall especially heavily on some agents but not on others. We show that the possibility of disaster states distorts risk prices and affects wealth inequality, even under calibrations in which they never occur in equilibrium. This paper was accepted by Lukas Schmid, finance. Funding: M. Ebrahimian acknowledges funding from the Swedish House of Finance. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2022.03068 .

Term structure of equity risk premia in rough terrain: 150 years of the French stock market

We implement a state-space modeling to capture jointly the one-year and infinite horizons equity risk premia (ERPs) over a secular period in France. Expected stock returns are represented by mixing traditional expectation processes, expected variances are from GARCHX models and risk prices are stochastic state variables estimated using the Kalman filter method. Represented by the spread between long-and short-term ERPs, the term structure strongly varies over time exhibiting a dominant downward sloping. Both expected variances and risk prices are highly at play in determining the ERPs term structure, the effects of restraints on borrowing and of international stock market contagion completing the explanation. Overall, our modeling provides rather similar results using US data. We finally show that the French ERPs term structure varies with the economic cycle, the cost of capital and the liquidity preference.

On the effects of pessimism toward pollution-driven disasters on equity premiums

On the effects of pessimism toward pollution-driven disasters on equity premiums

Neobanks in emerging markets: a risk assessment

Neobanks have risen as popular digital challengers to incumbent banks, especially in emerging markets (EMs) where the banking sector is often characterized by oligopolies. This article first estimates the value of Nubank and StoneCo in Brazil, two of the fastest-growing neobanks in Brazil. Normalizing revenue growth assumptions from their financial data, valuation models uncover that Nubank could be overvalued by about two times, whereas StoneCo could be undervalued by 80% of its fair value, as of March 19, 2024. This article then discusses firm-specific (high cumulative net operating losses, low long-term operating margins, high borrowing costs) and adherent macroeconomic (political uncertainty, foreign exchange risks, high equity risk premia) risks in EMs that explain the volatility in Nubank’s and StoneCo’s stock prices. These risks are instructive for understanding the challenges facing the business model of neobanks in EMs.

An Application of Multi-Factor Model on Anomaly in China Stock Market

An Application of Multi-Factor Model on Anomaly in China Stock Market

The Network Factor of Equity Pricing: A Signed Graph Laplacian Approach

Abstract The connections among firms exhibit heterogeneity, complexity, and dynamism, posing a challenge for traditional unsigned network models. This article proposes a signed graph Laplacian approach to construct a dynamic network index (DNI), quantifying the aggregate changes in the market network over time. A larger DNI indicates more significant changes in firms’ interconnectedness and in the market network structure. Firms with higher sensitivity to DNI exhibit lower expected returns. Incorporating DNI into conventional asset pricing models improves return predictability. Results are robust for multiple estimators, various factor models, and different selections of test assets. Our findings suggest that the network factor generates a significant equity risk premium.

Time‐varying risk preference and equity risk premium forecasting: The role of the disposition effect

AbstractThis study examines whether the disposition effect can explain time‐varying risk preference and predict the equity risk premium. To do so, we propose an augmented general autoregressive conditional heteroskedasticity (GARCH)‐in‐Mean model unraveling the complex relationship between unrealized gains/losses, realized returns, and the equity risk premium. In our model, the risk aversion coefficient varies with the market state of unrealized gains/losses. Using data from the US stock markets, we show strong evidence that the disposition effect drives time‐varying risk preference: The risk aversion coefficient is significantly positive during periods of unrealized gains, but insignificant during periods of unrealized losses. These findings reconcile the conflicting results of the risk‐return trade‐off in existing literature. Moreover, our model shows significant predictability of the equity risk premium, both in‐sample and out‐of‐sample. Incorporating our model's predictions can yield substantial utility gains for a mean‐variance investor. Our results indicate that the disposition effect leads to time‐varying risk preference and thus induces equity risk premium predictability.

Asset prices in a production network

The relative importance of sectoral and aggregate productivity shocks in asset pricing is examined using a nonlinear dynamic equilibrium model where heterogeneous sectors interact in a production network. The model accounts for the heterogeneity in sectoral stock returns and endogenously generates conditional heteroskedasticity and fat tails. The equity risk premium is shown to be driven by sectoral shocks – specially to investment good producers and mining – with a limited contribution from the aggregate shock. SMM estimates of the elasticities of substitution between material inputs and between investment goods support the assumption of gross complementarity employed by previous network literature.

Supply Side Implications of Ambiguity Aversion for Risk Premium and Risk-Free Rate Puzzles

Supply Side Implications of Ambiguity Aversion for Risk Premium and Risk-Free Rate Puzzles

Risk Premium and Volatility Analysis on Indonesia Stock Exchange

Market risk premium and market volatility are important in investment decisions. Volatility is an important variable in derivative securities which is a measure of changes in stock returns. The research focuses on stock return volatility, research that points to a risk premium in emerging markets. The purpose of this study is to explain the relationship between market equity premium and volatility using GARCH (1.1) on the Indonesia Stock Exchange. This research uses daily closing price data of the Indonesia Stock Exchange Composite Index (JCI). The result of this study, that there is a relationship between risk premium and volatility in the Indonesian stock market. The conclusion of this study is to try to test whether there is a relationship from the volatility of return to risk premium in the Indonesian stock market. Using the daily trend of the Indonesian stock market (IDX) from January 2010 to September 2023.

A consumption-based term structure model of bonds and equity

In this study, I propose a consumption-based asset pricing model to capture the dynamic properties of term structures of bonds and equity. I extend the long-run risks model by introducing a mean-reversion of dividend growth and the external habit formation of a representative agent. The mean-reverting dividend growth generates a negative equity term premium, while the habit formation augments the equity premium and renders an upward-sloping bond yield curve, on average. In addition, fluctuations in the surplus consumption ratio and the conditional variance of consumption growth allow the model to reproduce pro-cyclical variations in bond and equity yield spreads and counter-cyclical variations in bond and equity term premiums, as observed in the U.S. data.

Risk Premium for Emerging Market Equities Versus Developed Market Equities

The paper provides the most recent view on the difference in ERP (Equity Risk Premiums) across various economic regions, analyzing data sets from the early 2000s to May 2023. The study demonstrates a significant shift in the relationship between ERPs in emerging and developed markets over the past two decades, which runs contrary to the existing research on the matter. The author estimated the average ERPs per country and economic region, analyzed ERPs on the industry level, and conducted the regression analysis using macroeconomic factors and analysis of upside and downside betas. The research established that, following the 2008 economic crisis, developed markets displayed greater resilience to negative economic shocks. Moreover, investing in emerging markets entails higher risks, characterized by elevated negative beta and higher volatility, but also increased upside beta. The regression analysis revealed negative associations between ERP and higher GDP growth and local interest rates, while a positive correlation emerged with a higher unemployment rate. Additionally, the paper incorporates the Democracy Index, indicating that less democratic countries tend to exhibit higher ERPs.

Measuring macroeconomic tail risk

This paper estimates consumption and GDP tail risk dynamics over the long run (1900–2020). Our predictive approach circumvents the scarcity of large macroeconomic crises by exploiting a rich information set covering 42 countries. This flexible approach does not require asset price information and can thus serve as a benchmark to evaluate the empirical validity of rare disaster models. Our estimates covary with asset prices and forecast future stock returns, in line with theory. A calibration disciplined by our estimates supports the prediction that macroeconomic tail risk drives the equity premium.

Predicting the Equity Premium with Combination Forecasts: A Reappraisal

Abstract This paper reappraises the usefulness of combining individual forecasts for predicting the U.S. equity premium. For comparison, we also consider penalized regression and dimension reduction approaches. We fail to find evidence of predictive ability in recent decades, regardless of the forecasting method used. Further analysis shows that an increase in the correlation of individual forecast errors is an important factor in the declining performance of combination forecasts.()

Оценка нормирования прибыли и границ горной ренты I и II как экономический метод регулирования горного проекта

Based on the study of empirical economic data obtained during operation of a large-scale gold ore deposit, a model was built to justify the hypothesis about profit rationing, the formation and division of the differential rent I and II. The model identifies the increase in the equity premium as the sum of profit and rent II for investment capital and rent I for the owner of the resources. Boundaries of the capital movement are highlighted for the terms of service agreements with and without risk. The obtained values are attractive for the investment and/or operating side, and the resource owner during the field development. The approach based on profit rationing, assessment and division of the mining rent by types: (1) will help to introduce civil law relations in subsoil use based on service contracts with or without risk; (2) takes into account the value of reserves and resources in their mining and dividing them into ownerships, resources and investment capital; (3) introduces a new approach to attractiveness of deposit mining, both in attracting investment capital and for the operating companies based on a risk-free contract with retention of the ownership of resources with the country of the resource owner; (4) enhances the investment and production attractiveness of deposit mining providing incentives to introduce innovation technologies and improve the efficiency. It is possible to create an economic method for managing and regulating the mining industry of the Kyrgyz Republic based on the proposed approach.