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The Declining Equity Premium: What Role Does Macroeconomic Risk Play?


Martin Lettau


University of California - Haas School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Jessica A. Wachter


University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Sydney C. Ludvigson


New York University - Department of Economics; National Bureau of Economic Research (NBER)

February 2004

NBER Working Paper No. w10270

Abstract:     
Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy. We estimate a two-state regime switching model for the volatility and mean of consumption growth, and find evidence of a shift to substantially lower consumption volatility at the beginning of the 1990s. We then show that there is a strong and statistically robust correlation between low macroeconomic volatility and high asset prices: the estimated posterior probability of being in a low volatility state explains 30 to 60 percent of the post-war variation in the log price-dividend ratio, depending on the measure of consumption analyzed. Next, we study a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth, where the probabilities of a regime change are calibrated to match estimates from post-war data. Plausible parameterizations of the model are found to account for a significant fraction of the run-up in asset valuation ratios observed in the late 1990s.

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Date posted: May 25, 2006  

Suggested Citation

Lettau, Martin and Wachter, Jessica A. and Ludvigson, Sydney C., The Declining Equity Premium: What Role Does Macroeconomic Risk Play? (February 2004). NBER Working Paper No. w10270. Available at SSRN: http://ssrn.com/abstract=495775

Contact Information

Martin Lettau (Contact Author)
University of California - Haas School of Business ( email )
Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
5106436349 (Phone)
HOME PAGE: http://faculty.haas.berkeley.edu/lettau/
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Jessica A. Wachter
University of Pennsylvania - Finance Department ( email )
The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-7634 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Sydney C. Ludvigson
New York University - Department of Economics ( email )
19 West 4th Street, 6th floor
New York, NY 10012
United States
212-998-8927 (Phone)
212-995-4186 (Fax)
HOME PAGE: http://www.econ.nyu.edu/user/ludvigsons/
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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