Where Do Equity Risk Premia Come From?
15 Pages Posted: 7 Jul 2020 Last revised: 10 Nov 2020
Date Written: November 9, 2020
Standard finance theory posits that equity risk premia compensate for occasional shortfalls in aggregate consumption. However, observed premia are much higher than typical consumption risks warrant. Insurance against rare disaster risks reconciles only some of the differential, unless risk aversion is implausibly high and if equity dividends are mis-identified with aggregate consumption. Equity markets are better modeled as casino games with evolving risks, with pricing dominated by rational gamblers seeking long-term enrichment. While their effective risk aversion is modest, the risks of drawdown appear high enough to justify a risk premium of several hundred basis points.
Keywords: risk premium, equity pricing, expected utility, constant relative risk aversion, intertemporal elasticity of substitution, disaster risks, Kelly criterion, fractional Kelly
JEL Classification: D11, G11, G12
Suggested Citation: Suggested Citation