Is the Ex Ante Premium Always Positive? Evidence and Analysis from Australia

UNSW School of Banking and Finance Working Paper Series No. 2004 -14

37 Pages Posted: 12 Jan 2005

See all articles by Kathleen D. Walsh

Kathleen D. Walsh

University of Technology Sydney (UTS)

Date Written: October 2004

Abstract

An implicit assumption of the conditional CAPM is that the ex ante market risk premium is positive in all states of the world. Studies on US portfolios by Boudoukh, Richardson and Smith (1993) and on World portfolios by Ostdiek (1998) find violations of this assumption. This paper seeks to test the sign of the market risk premium in the Australian Market using two parallel tests. Firstly, the series is examined for the presence of two regimes using a test developed in Bayesian inference. Truncated normal priors are applied to the means in this test to specifically detect means of opposite sign. Secondly, we applied the test developed by Boudoukh, Richardson and Smith (1993) which allows the moments implied by the model to be conditioned on observable information, using an instrumental variables approach. We were able to reject the null of a single regime in favour of the two regime model using the regime switching test. In addition the inequality tests rejected the restriction of a positive risk premium. The combination of a dual regime and a negative ex ante risk premium is a rejection of the assumption of positivity required for the conditional CAPM.

Keywords: Bayesian analysis, Equity Risk Premium, regime switching

JEL Classification: C11, G12

Suggested Citation

Walsh, Kathleen D., Is the Ex Ante Premium Always Positive? Evidence and Analysis from Australia (October 2004). UNSW School of Banking and Finance Working Paper Series No. 2004 -14, Available at SSRN: https://ssrn.com/abstract=641446 or http://dx.doi.org/10.2139/ssrn.641446

Kathleen D. Walsh (Contact Author)

University of Technology Sydney (UTS) ( email )

15 Broadway, Ultimo
PO Box 123
Sydney, NSW 2007
Australia

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