The Equity Premium Puzzle: High Required Premium, Undervaluation and Self Fulfilling Prophecy

25 Pages Posted: 29 Sep 2008 Last revised: 27 Dec 2008

See all articles by Pablo Fernandez

Pablo Fernandez

University of Navarra - IESE Business School

Javier Aguirreamalloa

IESE Business School

Heinrich Liechtenstein

University of Navarra - IESE Business School

Date Written: December 26, 2008

Abstract

Mehra and Prescott (1985) argued that, according to sensible asset pricing models, stocks should provide at most a 0.35% premium over bills. However, companies use higher equity premia (average around 6%) for evaluating their investment projects, professors use in class and in their textbooks higher equity premia (average around 6%, range from 3 to 10%) and investors use higher equity premia for valuing companies. The overall result is that equity prices are, on average, undervalued (and have been undervalued in the last decades) and, consequently, the measured ex-post equity premium (HEP) is also high.

If the additional returns beyond the risk-free rate demanded by equity investors (ex-ante risk premia) and used in financial asset pricing models have been high, it is not a surprise that the ex-post risk premia (calculated with historical data) have been also high. If most investors use historical data to estimate the required and the expected equity premium, the undervaluation and the high ex-post risk premium are self fulfilling prophecies.

Keywords: equity premium puzzle, required equity premium, historical equity premium

JEL Classification: G12, G31, M21

Suggested Citation

Fernandez, Pablo and Aguirreamalloa, Javier and Liechtenstein, Heinrich, The Equity Premium Puzzle: High Required Premium, Undervaluation and Self Fulfilling Prophecy (December 26, 2008). IESE Business School Working Paper. Available at SSRN: https://ssrn.com/abstract=1274816 or http://dx.doi.org/10.2139/ssrn.1274816

Pablo Fernandez (Contact Author)

University of Navarra - IESE Business School ( email )

Camino del Cerro del Aguila 3
28023 Madrid
Spain
+34 91 357 0809 (Phone)
+34 91 357 2913 (Fax)

HOME PAGE: http://web.iese.edu/PabloFernandez/

Javier Aguirreamalloa

IESE Business School ( email )

08034 Barcelona
Spain

Heinrich Liechtenstein

University of Navarra - IESE Business School ( email )

Avenida Pearson 21
Barcelona, 08034
Spain

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