Can Rare Events Explain the Equity Premium Puzzle?

49 Pages Posted: 13 Mar 2008

See all articles by Christian Julliard

Christian Julliard

London School of Economics & Political Science (LSE) - Department of Finance; Centre for Economic Policy Research (CEPR)

Anisha Ghosh

London School of Economics & Political Science (LSE)

Multiple version iconThere are 2 versions of this paper

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

Julliard, Christian and Ghosh, Anisha, Can Rare Events Explain the Equity Premium Puzzle? (March 7, 2008). Available at SSRN: https://ssrn.com/abstract=1104760 or http://dx.doi.org/10.2139/ssrn.1104760

Christian Julliard (Contact Author)

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Anisha Ghosh

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

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