Market Effciency, Asset Returns, and the Size of the Risk Premium in Global Equity Markets
Posted: 20 Feb 2002
An important economic insight is that observed equity prices must equal the present value of the cash flows associated with the equity claim. An implication of this insight is that present values of cash flows must also quantitatively justify the observed volatility and cross-correlations of asset returns. In this paper, we show that parametric economic models for present values can indeed account for the observed high ex-post return volatility and cross-correlation observed across five major equity markets. We present evidence that cash flow growth rates contain a small predictable long-run component; this feature, in conjuction with time-varying systematic risk, can justify key empirical characteristics of observed equity prices. In many cases, our model can also capture observed equity price levels. Our evidence suggests that the ex-ante risk premium on the global market portfolio has dropped considerably - we show that this fall in the risk premium is related to a decline in the conditional variance of global real cash flow growth rates.
Keywords: Asset volatility, Correlation, Cash Flows, Risk Premia, Fundamental Values
JEL Classification: F3, G0, C1, C5
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