Conditioned Diffusions and the Equity Premium

Abstract

We apply the theory of conditioned diffusions to consider the effect of survivorship bias on a variety of issues in empirical finance. We provide a spatial analysis of this phenomenon as opposed to the more temporal analysis of Brown, Goetzmann and Ross (1995). We find that survivorship bias generates a high spurious equity premium in the 1930s when survival concerns were the highest. These findings are consistent with the analysis of Stambaugh and Pastor (2001). We also find that survivorship effects can explain some of the equity premiums in emerging markets, which are typically quite high. Finally, we provide closed form solutions for the effect of survivorship bias on dividend-yield regressions.

Keywords: equity premium puzzle, conditioned diffusions, dividend yield regressions.

JEL Classification: G12