Equity Risk Premium Puzzle Research Articles

The Equity Risk Premium Puzzle in Pakistan

Our study uses the consumption-based asset-pricing power utility model to test theEquity Risk Premium (ERP) puzzle in Pakistan. The study has collected monthly stock pricedata from July 1997 to December 2017 from the PSX data portal. We extracted informationabout macroeconomic factors such as inflation and risk-free interest rate from the State Bankof Pakistan. Moreover, the study used private consumption and population data from thePakistan Bureau of Statistics. The results suggest that the ERP puzzle has a strong occurrencein Pakistan, a phenomenon previously associated with only developed markets. Onedisadvantage of the present investigation is the small sample size. A longer time durationcould have reduced short-term biases. Past researchers have suggested different approachesfor solving the equity premium puzzle. For instance, some studies used improvised structuralmodels to justify the equity risk premium puzzle using macroeconomic factors.

Equity Risk Premium Puzzle: Evidence from Indonesia and Sri Lanka

This paper investigates the equity risk premium puzzle in the Indonesian and Sri Lankan stock markets in order to identify the relationship between the volatility of excess returns and the equity risk premium. The asymmetric impact of negative shocks on the equity risk premium is also examined using threshold and exponential GARCH-M models. We analyse data on the excess returns of the Indonesian and Sri Lankan stock markets from 2004 to 2013, and we find that the impact of the conditional volatility of excess returns on the equity risk premium is not significant in either country. Instead, we find an impact from negative return shocks on the equity risk premium only in Sri Lanka. Therefore, we conclude that investors are not compensated for the conditional volatility of the excess returns in these two markets, while Sri Lankan investors are compensated for the risk of negative shocks.

Solving the Equity Risk Premium Puzzle and Inching Toward a Theory of Everything

The equity risk premium puzzle is that the return on equities has far exceeded the average return on short-term risk-free debt and cannot be explained by conventional representative-agent consumption based equilibrium models. We review a few attempts done over the years to explain this anomaly: 1. Inclusion of highly unlikely events with low probability (Ugly state along with Good and Bad), or market crashes / Black Swans. 2. Slow moving habit, or time-varying subsistence level, added to the basic power utility function. 3. A separation of the inter-temporal elasticity of substitution and risk aversion, combined with long run risks which captures time varying economic uncertainty. We explore whether a fusion of the above approaches supplemented with better methods to handle the below reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences: 1. Unlimited ability of individuals to invest as compared to their ability to consume. 2. Lack of an objective measuring stick of value 3. Unintended consequences due to the dynamic nature of social systems 4. Relaxation of the transversality condition to avoid the formation of asset price bubbles 5. How durable is durable? Accounting for durable goods since nothing lasts forever The world we live in produces fascinating phenomenon despite (or perhaps, due to) being a hotchpotch of varying doses of the above elements. The rationale for a unified theory is that beauty can emerge from chaos since the best test for a stew is its taste. Many long standing puzzles seem to have been resolved using different techniques. The various explanations need to stand the test of time before acceptance; but then unexpected outcomes set in and new puzzles emerge. As real analysis and limits tell us: We are getting Closer and Closer; Yet it seems we are still Far Far Away...

Solving the Equity Risk Premium Puzzle and Inching Towards a Theory of Everything -- Visual Version

The equity risk premium puzzle is that the return on equities has far exceeded the average return on short-term risk-free debt and cannot be explained by conventional representative-agent consumption based equilibrium models. We review a few attempts done over the years to explain this anomaly:1. Inclusion of highly unlikely events with low probability (Ugly state along with Good and Bad), or market crashes, recently also termed as Black Swans.2. Slow moving habit, or time-varying subsistence level, added to the basic power utility function.3. Allowing for a separation of the inter-temporal elasticity of substitution and risk aversion, combined with consumption and dividend growth rates modeled as containing a small persistent expected growth rate component and a fluctuating volatility which captures time varying economic uncertainty.We explore whether a fusion of the above approaches supplemented with better methods to handle the below reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences:1. Unlimited ability of individuals to invest as compared to their ability to consume.2. Lack of an objective measuring stick of value which gives rise to heterogeneous preferences and beliefs.3. Unintended consequences due to the dynamic nature of social systems, where changes can be observed and decisions effected by participants to influence the system.4. Relaxation of the transversality condition to avoid the formation of asset price bubbles.5. How durable is durable? Since nothing lasts forever, accounting for durable goods to create a comprehensive measure of consumption volatility .The world we live in produces fascinating phenomenon despite (or perhaps, due to) being a hotchpotch of varying doses of the above elements. The rationale for a unified theory is that beauty can emerge from chaos since the best test for a stew is its taste.

Solving the Equity Risk Premium Puzzle and Inching Towards a Theory of Everything

The equity risk premium puzzle is that the return on equities has far exceeded the average return on short-term risk-free debt and cannot be explained by conventional representative-agent consumption based equilibrium models. We review a few attempts done over the years to explain this anomaly:1. Inclusion of highly unlikely events with low probability (Ugly state along with Good and Bad), or market crashes, recently also termed as Black Swans.2. Slow moving habit, or time-varying subsistence level, added to the basic power utility function.3. Allowing for a separation of the inter-temporal elasticity of substitution and risk aversion, combined with consumption and dividend growth rates modeled as containing a small persistent expected growth rate component and a fluctuating volatility which captures time varying economic uncertainty.We explore whether a fusion of the above approaches supplemented with better methods to handle the below reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences:1. Unlimited ability of individuals to invest as compared to their ability to consume.2. Lack of an objective measuring stick of value which gives rise to heterogeneous preferences and beliefs.3. Unintended consequences due to the dynamic nature of social systems, where changes can be observed and decisions effected by participants to influence the system.4. Relaxation of the transversality condition to avoid the formation of asset price bubbles.5. How durable is durable? Since nothing lasts forever, accounting for durable goods to create a comprehensive measure of consumption volatility.The world we live in produces fascinating phenomenon despite (or perhaps, due to) being a hotchpotch of varying doses of the above elements. The rationale for a unified theory is that beauty can emerge from chaos since the best test for a stew is its taste. Many long standing puzzles seem to have been resolved using different techniques. The various explanations need to stand the test of time before acceptance; but then unexpected outcomes set in and new puzzles emerge. As real analysis and limits tell us: we are getting Closer and Closer; Yet it seems we are still Far Far Away...

Another Look at the Equity Risk Premium Puzzle

Abstract The model of Mehra and Prescott (1985, J. Econometrics, 22, 145-161) implies that reasonable coefficients of risk-aversion of economic agents cannot explain the equity risk premium generated by financial markets. This discrepancy is hitherto regarded as a major financial puzzle. We propose an alternative model to explain the equity premium. For normally distributed returns and for returns far away from normality (but still light tailed), realistic equity risk premia do not imply puzzlingly high risk aversions. Following our approach, the ‘equity premium puzzle’ does not exist. We also consider fat-tailed return distributions and show that Pareto tails are incompatible with constant relative risk aversion.

Equity Risk Premium Puzzle: Case of Indian Stock Market

Equity has always remained an instrument of long term wealth creation. India being a developing nation with low average age group and rising per capita income; investment in equity may provide a significant wealth creation opportunity provided equity risk premium (ERP) is significant enough. ERP also helps in identifying the cost of equity and cost of capital of the business and hence, provide valuable insights for project appraisal decisions. This paper answers the question “Is the ERP offered by Indian stock market justifiable?”

Equity risk premium and insecure property rights

How much of the equity risk premium puzzle can be attributed to the insecure property rights of shareholders? This paper develops a version of the CCAPM with insecure property rights (stochastic taxes). The model implies that the current expected equity premium can be reconciled with a coefficient of relative risk aversion of 3.76, thus resolving a substantial part of the equity premium puzzle.

Rare Disasters and Asset Markets in the Twentieth Century*

The potential for rare economic disasters explains a lot of asset-pricing puzzles. I calibrate disaster probabilities from the twentieth century global history, especially the sharp contractions associated with World War I, the Great Depression, and World War II. The puzzles that can be explained include the high equity premium, low risk-free rate, and volatile stock returns. Another mystery that may be resolved is why expected real interest rates were low in the United States during major wars, such as World War II. The model, an extension of work by Rietz, maintains the tractable framework of a representative agent, timeadditive and isoelastic preferences, and complete markets. The results hold with i.i.d. shocks to productivity growth in a Lucas-tree type economy and also with the inclusion of capital formation. The Mehra-Prescott [1985] article on the equity risk-premium puzzle has received a great deal of attention. An article published three years later by Rietz [1988] purported to solve the puzzle by bringing in low-probability economic disasters, such as the Great Depression. I think that Rietz’s basic reasoning is correct, but the profession seems to think differently, as gauged by the continued attempts to find more and more complicated ways to resolve the equity-premium puzzle. I think the major reason for skepticism about Rietz’s argument is the belief that it depends on counterfactually high probabilities and sizes of economic disasters. Thus, a key aspect of my empirical analysis is the measurement of the frequency and sizes of the international economic disasters that occurred during the twentieth century. The three principal events are World War I, the Great Depression, and World War II, but post-World War II depressions have also been significant outside of OECD countries. My analysis of these events suggests a disaster probability of 1.5–2 percent per year with a distribution of declines in per capita GDP ranging between 15 percent and 64 percent. I construct a model of the equity premium that extends Lucas

Cross-country and intertemporal indexes of risk aversion

One of the most common and firmly held views of financial economics is that investors are averse to risk. Although a formal description of risk aversion was proposed by the celebrated mathematician, Daniel Bernoulli, as early as 1738, financial economists are still puzzled about many aspects of risk aversion, including the fact that the realised premium of equities over a risk free asset is too large to accord with ‘normal’ notions of risk aversion. This discrepancy is known as the equity risk premium puzzle. There is also vigorous debate as to the effect of horizon on the willingness of investors to bear risk. To help address these issues and other questions related to risk aversion, a methodology is introduced to infer risk aversion from global portfolio flows and holdings. Specifically, the authors derive a formula for risk aversion based on the assumption that investors maximise expected utility by allocating their portfolio between assets of differing risk. The authors use this formula to approximate the risk aversion of US investors towards specific countries. They demonstrate that risk aversion, as they approximate it, helps to predict bond and stock returns, as well as risk premiums one period forward.

Habit Formation and Dynamic Demand Functions

Most economists would agree that past consumption patterns are an important determinant of present consumption patterns, and that one ought to distinguish between long-run and short-run demand functions. But although the distinction between long-run and short-run behavior is traditional in the theory of the firm, it is seldom made in the theory of consumer behavior. If we regard demand theory as a theory of how a given amount of money (expenditure, called income) is allocated among goods, then-in a world without consumer durables-there are three reasons why longand shortrun demand functions might differ. (i) The consumer may have contractually fixed commitments which prevent him from adjusting some portion of his consumption (for example, housing) in response to changes in prices or income. When these fixed commitments lapse, he is able to adjust to his long-run equilibrium. (ii) The consumer may be ignorant of consumption possibilities or of his own tastes outside the range of his past consumption experience. In this case his adjustment to a new price-income situation will involve a time-consuming learning process. (iii) Finally, goods may be "habit forming" so that an individual's current preferences depend on his past consumption patterns. In this case a change in prices or income will cause a change-in consumption which will induce a change in tastes, which will cause a further change in consumption. In this paper I formulate a model of consumer behavior based on habit formation, beginning with a specific class of demand functions derived from the "modified Bergson family" of utility functions. The properties of these utility functions and the corresponding demand functions are briefly summarized in Section 1. I then postulate that the parameters