Equity Premium Puzzle Flashcards
Mars & Stanton Equity premium puzzle study
Risk premium is a compensation required by investors by definition it is expected. However historical excess return over risk free rate is referred as risk premium. These historical premiums are shrinking overtime and experts’ estimates hugely vary from one other.
What we are interested is that are they biased upwards?
16 markets’ 103 years of data analysed and evidence shows
1. US bias is present
2. longer period required, as some short periods have negative r
3. Survivorship bias – countries with -100% r such as Russia etc omitted
Mars and Stanton found world risk premium to be geometric mean=3% and arithmetic=5% which they are much lower than what was considered in Finance.
The puzzle is historic excess returns are too high or investors are too risk averse. 1. Hanlon and Steele (computing implied cost of capital based on consumption)
Consumption might be a better estimate of risk rather than wealth, so these researchers estimated consumption β and found excess return depend on consumption growth as oppose to market.
2. DDM approach by FF
They found that the difference between expected and realised return is the difference between capital gain and dividend growth rate. Their conclusion about Equity premium puzzle was due to unanticipated capital gains after 1949.
3. Intuitively the part of equity premium is also due to a compensation for liquidity risk, rather than just systemic risk.
