Equity premium puzzle

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The equity premium puzzle is a term coined by economists Rajnish Mehra and Edward C. Prescott. It is based on the observation that in order to reconcile the much higher return on stock compared to government bonds in the United States, individuals must have implausibly high risk aversion according to standard economics models. Similar situations prevail in many other industrialized countries. The puzzle has led to an extensive research effort in both macroeconomics and finance. So far a range of useful theoretical tools and several plausible explanations have been presented, but a solution generally accepted by the economics profession remains elusive.

In the United States, the observed equity premium, or more precisely the risk premium for equity, over the past century is approximately an annualized average 6 percentage points. (However, over any one decade, the equity premium has great variability - from over 19% in the 1950s to 0.3% in the 1970s.) It is this gap that is much larger than would be predicted on the basis of standard models of financial markets and assumptions about risk attitudes. To quantify the level of risk aversion implied, investors would have to be indifferent between a bet equally likely to pay $50,000 or $100,000 (an expected value of $75,000) and a certain payoff of $51,209 (Benartzi and Thaler, 1995).

Contents 1 Possible explanations 1.1 Individual characteristics 1.2 Equity characteristics 1.3 Tax distortions 1.4 Market failure explanations 1.5 VIX (implied volatility) 2 Implications 3 See also 4 References

[edit] Possible explanations

A large number of explanations for the puzzle have been proposed. These include a contention that the puzzle is a statistical illusion, modifications to the assumed preferences of investors and imperfections. Kocherlakota (1996), Mehra and Prescott (2003) present a detailed analysis of these explanations in financial markets and conclude that the puzzle is real and remains unexplained. Subsequent reviews of the literature have similarly found no agreed resolution.

Grant and Quiggin (2006) distinguish several classes of explanation of the puzzle.

[edit] Individual characteristics

Some explanations rely on assumptions about individual behavior and preferences different from those made by Mehra and Prescott. Examples include the prospect theory model of Benartzi and Thaler (1995) based on loss aversion A problem for this model is the lack of a general model of portfolio choice and asset valuation for prospect theory.

A second class of explanations is based on relaxation of the optimization assumptions of the standard model. The standard model represents consumers as continuously-optimizing dynamically-consistent expected-utility maximizers. These assumptions provide a tight link between attitudes to risk and attitudes to variations in intertemporal consumption which is crucial in deriving the equity premium puzzle. Solutions of this kind work by weakening the assumption of continuous optimization, for example by supposing that consumers adopt satisficing rules rather than fully optimizing. An example is info-gap decision theory (Ben-Haim, 2006), based on a non-probabilistic treatment of uncertainty, which leads to the adoption of a robust satisficing approach to asset allocation.

[edit] Equity characteristics

A second class of explanations focuses on characteristics of equity not captured by standard capital market models, but nonetheless consistent with rational optimization by investors in smoothly functioning markets. Writers including Bansal and Coleman (1996), Palomino (1996) and Holmstrom and Tirole (1998) focus on the demand for liquidity.

[edit] Tax distortions

McGrattan and Prescott (2001) argue that the observed equity premium in the United States since 1945 may be explained by changes in the tax treatment of interest and dividend income. As Mehra (2003) notes, there are some difficulties in the calibration used in this analysis and the existence of a substantial equity premium before 1945 is left unexplained.

[edit] Market failure explanations

Two broad classes of market failure have been considered as explanations of the equity premium. First, problems of adverse selection and moral hazard may result in the absence of markets in which individuals can insure themselves against systematic risk in labor income and noncorporate profits. Second, transactions costs or liquidity constraints may prevent individuals from smoothing consumption over time.

[edit] VIX (implied volatility)

Graham and Harvey ^[1] have estimated that for USA the expected average premium during June 2000 to Nov. 2006 has ranged between 4.65 to 2.50. They found a modest correlation of 0.62 between VIX and 10-year premium.

[edit] Implications

The magnitude of the equity premium has implications for resource allocation, social welfare, and economic policy. Grant and Quiggin (2005) derive the following implications of the existence of a large equity premium:

• That the macroeconomic variability associated with recessions is very expensive
• That risk to corporate profits robs the stock market of most of its value
• That corporate executives are under irresistible pressure to make short-sighted, myopic decisions
• That policies—disinflation, costly reform—that promise long-term gains at the expense of short-term pain are much less attractive if their benefits are risky
• That social insurance programs might well benefit from investing their resources in risky portfolios in order to mobilize additional risk-bearing capacity
• That there is a strong case for public investment in long-term projects and corporations, and for policies to reduce the cost of risky capital
• That transaction taxes could be either for good or for ill

[edit] See also

• Ellsberg paradox
• Loss aversion
• Risk aversion
• List of cognitive biases
• Economic puzzle

[edit] References

1. ^ The Equity Risk Premium in January 2007: Evidence from the Global CFO Outlook Survey, John R. Graham,Campbell R. Harvey

• Mehra, Rajnish; Edward C. Prescott (1985). "The Equity Premium: A Puzzle". Journal of Monetary Economics 15: 145-161. 
• Kocherlakota, Narayana R. (March 1996). "The Equity Premium: It's Still a Puzzle". Journal of Economic Literature 34 (1): 42-71. 
• Mehra, Rajnish; Edward C. Prescott (2003). "The Equity Premium Puzzle in Retrospect", in G.M. Constantinides, M. Harris and R. Stulz: Handbook of the Economics of Finance. Amsterdam: North Holland, 889-938. ISBN 978-0-444-51363-2. 
• Benartzi, Shlomo; Richard H. Thaler (Feb. 1995). "Myopic Loss Aversion and the Equity Premium Puzzle". The Quarterly Journal of Economics 110 (1): 73-92.  (subscription required to download paper)
• Yakov Ben-Haim, Info-Gap Decision Theory: Decisions Under Severe Uncertainty, Academic Press, 2nd edition, Sep. 2006. ISBN 0-12-373552-1.
• Grant, S. and Quiggin, J. (2006), "The risk premium for equity: implications for resource allocation, welfare and policy," Australian Economic Papers, 45(3), 253–68. [1]