Maximum Likelihood Estimation of the Equity Premium
The Wharton School Research Paper No. 57
Jacobs Levy Equity Management Center for Quantitative Financial Research Paper
69 Pages Posted: 30 May 2014 Last revised: 12 Aug 2020
There are 2 versions of this paper
Maximum Likelihood Estimation of the Equity Premium
Maximum Likelihood Estimation of the Equity Premium
Date Written: September 12, 2016
Abstract
The equity premium, namely the expected return on the aggregate stock market less the government bill rate, is of central importance to the portfolio allocation of individuals, to the investment decisions of firms, and to model calibration and testing. This quantity is usually estimated from the sample average excess return. We propose an alternative estimator, based on maximum likelihood, that takes into account information contained in dividends and prices. Applied to the postwar sample, our method leads to an economically significant reduction from 6.4% to 5.1%. Simulation results show that our method produces more reliable estimates under a wide range of specifications.
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