Estimating the Equity Premium

52 Pages Posted: 19 Nov 2006 Last revised: 30 Jul 2010

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: November 1, 2008

Abstract

Existing empirical research investigating the size of the equity premium has largely consisted of a series of innovations around a common theme: producing a better estimate of the equity premium by using better data or a better estimation technique. The equity premium estimate that emerges from most of this work matches one moment of the data alone: the mean difference between an estimate of the return to holding equity and a risk free rate. We instead match multiple moments of US market data, exploiting the joint distribution of the dividend yield, return volatility and realized excess returns, and find that the equity premium lies within 50 basis points of 3.5%, a range much narrower than achieved in previous studies. Additionally, statistical tests based on the joint distribution of these moments reveal that only those models of the conditional equity premium that embed time variation, breaks, and/or trends are supported by the data. In order to develop the joint distribution of the dividend yield, return volatility and excess returns, we need a model of price and return fundamentals. We document that even recently developed analytically tractable models which permit autocorrelated dividend growth rates and discount rates impose restrictions that are rejected by the data. We therefore turn to a wider range of models, requiring numerical solution methods and parameter estimation by Simulated Method of Moments.

Keywords: equity risk premium, simulated method of moments, SMM

JEL Classification: G12, C13, C15, C22

Suggested Citation

Donaldson, Glen and Kamstra, Mark J. and Kramer, Lisa A., Estimating the Equity Premium (November 1, 2008). Journal of Financial and Quantitative Analysis, August 2010, 45(4) ; Rotman School of Management Working Paper No. 07-02. Available at SSRN: https://ssrn.com/abstract=945192

Glen Donaldson

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

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

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
Canada
416-978-2496 (Phone)
416-971-3048 (Fax)

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

Paper statistics

Downloads
746
Rank
25,617
Abstract Views
2,766