Dissecting the Equity Premium

25 Pages Posted: 13 Sep 2019 Last revised: 2 May 2021

Date Written: May 1, 2021

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, leading 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.

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

JEL Classification: G12, G13

Suggested Citation

Beason, Tyler and Schreindorfer, David, Dissecting the Equity Premium (May 1, 2021). Available at SSRN: https://ssrn.com/abstract=3452743 or http://dx.doi.org/10.2139/ssrn.3452743

Tyler Beason

Virginia Tech ( email )

Blacksburg, VA 24061
United States

David Schreindorfer (Contact Author)

Arizona State University ( email )

Farmer Building 440G PO Box 872011
Tempe, AZ 85287
United States
4809656212 (Phone)

HOME PAGE: http://www.davidschreindorfer.com

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