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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)

June 29, 2004

AFA 2005 Philadelphia Meetings; 14th Annual Utah Winter Finance Conference Paper

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. Empirically, we find a strong correlation between low frequency movements in macroeconomic volatility and low frequency movements in the stock market. To model this phenomenon, 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 use these estimates from post-war data to calibrate a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth. Plausible parameterizations of the model are found to account for a significant portion of the run-up in asset valuation ratios observed in the late 1990s.

Number of Pages in PDF File: 59

JEL Classification: G12

working papers series


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Date posted: August 12, 2004  

Suggested Citation

Lettau, Martin and Wachter, Jessica A. and Ludvigson, Sydney C., The Declining Equity Premium: What Role Does Macroeconomic Risk Play? (June 29, 2004). AFA 2005 Philadelphia Meetings; 14th Annual Utah Winter Finance Conference Paper. Available at SSRN: http://ssrn.com/abstract=575321 or http://dx.doi.org/10.2139/ssrn.575321

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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