Can Rare Events Explain the Equity Premium Puzzle?
49 Pages Posted: 13 Mar 2008
There are 2 versions of this paper
Can Rare Events Explain the Equity Premium Puzzle?
Can Rare Events Explain the Equity Premium Puzzle?
Date Written: March 7, 2008
Abstract
Probably not. First, allowing the probabilities attached to the states of the economy to differ from their sample frequencies, the Consumption-CAPM is still rejected by the data and requires a very high level of Relative Risk Aversion (RRA) in order to rationalize the stock market risk premium. This result holds for a variety of data sources and samples - including the ones starting as far back as 1890. Second, we elicit the likelihood of observing an Equity Premium Puzzle (EPP) if the data were generated by the rare events probability distribution needed to rationalize the puzzle with a low level of RRA. We find that the historically observed EPP would be very unlikely to arise. Third, we find that the rare events explanation of the EPP significantly worsens the ability of the Consumption-CAPM to explain the cross-section of asset returns. This is due to the fact that, by assigning higher probability to bad - economy wide - states in which consumption growth is low and all the assets in the cross-section tend to yield low returns, the rare events hypothesis reduces the cross-sectional dispersion of consumption risk relative to the cross-sectional variation of average returns.
Keywords: Rare Events, Rare Disasters, Equity Premium Puzzle, Generalized Empirical Likelihood, Semi-parametric Bayesian Inference, Calibration, Cross-Section of Asset Returns, Peso Phenomenon
JEL Classification: C11, C14, E17, G12
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Consumption, Aggregate Wealth and Expected Stock Returns
By Martin Lettau and Sydney C. Ludvigson
-
Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles
By Ravi Bansal and Amir Yaron
-
Dividend Yields and Expected Stock Returns: Alternative Procedures for Interference and Measurement
-
Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia are Time-Varying
By Martin Lettau and Sydney C. Ludvigson
-
Stock Return Predictability: Is it There?
By Geert Bekaert and Andrew Ang
-
Stock Return Predictability: Is it There?
By Geert Bekaert and Andrew Ang
-
Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia Wre Time-Varying
By Martin Lettau and Sydney C. Ludvigson