Stare Down the Barrel and Center the Crosshairs: Targeting the Ex Ante Equity Premium
FRB of Atlanta Working Paper No. 2003-4
63 Pages Posted: 19 Mar 2003
Date Written: January 2003
Abstract
The equity premium of interest in theoretical models is the extra return investors anticipate when purchasing risky stock instead of risk-free debt. Unfortunately, we do not observe this ex ante premium in the data; we only observe the returns that investors actually receive ex post, after they purchase the stock and hold it over some period of time during which random economic shocks affect prices. Over the past century U.S. stocks have returned roughly 6 percent more than risk-free debt, which is higher than warranted by standard economic theory; hence the "equity premium puzzle." In this paper we devise a method to simulate the distribution from which ex post equity premia are drawn, conditional on various assumptions about investors' ex ante equity premium. Comparing statistics that arise from our simulations with key financial characteristics of the U.S. economy, including dividend yields, Sharpe ratios, and interest rates, suggests a much narrower range of plausible equity premia than has been supported to date. Our results imply that the true ex ante equity premium likely lies very close to 4 percent.
Keywords: equity risk premium, equity premium puzzle, Monte Carlo simulation
JEL Classification: G12, C13, C15, C22
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior
By John Y. Campbell and John H. Cochrane
-
By Force of Habit: A Consumption-Based Explanation of Plantation of Aggregate Stock Market Behavior
By John Y. Campbell and John H. Cochrane
-
Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing
By John Heaton and Deborah J. Lucas
-
Asset Prices Under Habit Formation and Catching Up with the Joneses
-
Implications of Security Market Data for Models of Dynamic Economies
-
Myopic Loss Aversion and the Equity Premium Puzzle
By Shlomo Benartzi and Richard H. Thaler