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Stare Down the Barrel and Center the Crosshairs: Targeting the Ex Ante Equity Premium

FRB of Atlanta Working Paper No. 2003-4

Sauder School of Business Working Paper

63 Pages Posted: 19 Mar 2003  

R. Glen Donaldson

University of British Columbia (UBC) - Sauder School of Business

Mark J. Kamstra

York University - Schulich School of Business; Rady School of Management

Lisa A. Kramer

University of Toronto - Rotman School of Management

Date Written: January 2003

Abstract

The equity premium of interest in theoretical models is the extra return investors anticipate when purchasing risky stock instead of risk-free debt. Unfortunately, we do not observe this ex ante premium in the data; we only observe the returns that investors actually receive ex post, after they purchase the stock and hold it over some period of time during which random economic shocks affect prices. Over the past century U.S. stocks have returned roughly 6 percent more than risk-free debt, which is higher than warranted by standard economic theory; hence the "equity premium puzzle." In this paper we devise a method to simulate the distribution from which ex post equity premia are drawn, conditional on various assumptions about investors' ex ante equity premium. Comparing statistics that arise from our simulations with key financial characteristics of the U.S. economy, including dividend yields, Sharpe ratios, and interest rates, suggests a much narrower range of plausible equity premia than has been supported to date. Our results imply that the true ex ante equity premium likely lies very close to 4 percent.

Keywords: equity risk premium, equity premium puzzle, Monte Carlo simulation

JEL Classification: G12, C13, C15, C22

Suggested Citation

Donaldson, R. Glen and Kamstra, Mark J. and Kramer, Lisa A., Stare Down the Barrel and Center the Crosshairs: Targeting the Ex Ante Equity Premium (January 2003). FRB of Atlanta Working Paper No. 2003-4; Sauder School of Business Working Paper. Available at SSRN: https://ssrn.com/abstract=308743 or http://dx.doi.org/10.2139/ssrn.308743

R. Glen Donaldson

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Department of Finance
Vancouver BC V6T 1Z2
Canada
604-822-8344 (Phone)
604-822-8521 (Fax)

Mark J. Kamstra

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

Lisa A. Kramer (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-978-2496 (Phone)
416-971-3048 (Fax)

HOME PAGE: http://www.chass.utoronto.ca/~lkramer

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