Dissecting the Equity Premium

Abstract

We use option prices and realized returns to decompose risk premia into different parts of the return state space. In the data, 8/10 of the average equity premium is attributable to monthly returns below -10%, but returns below -30% matter very little. In contrast, prominent asset pricing models based on habits, long-run risks, rare disasters, undiversifiable idiosyncratic risk, and constrained intermediaries attribute the premium predominantly to returns above -10% or to the extreme left tail. We show that the discrepancy arises from an unrealistically small price of risk for stock market tail events in the models.

Keywords: tail risk, equity premium puzzle, equity index options, Arrow-Debreu securities, rare disasters, long-run risks, external habits, incomplete markets, intermediary-based asset pricing

JEL Classification: G12, G13