Lecture 8-Market Anomalies in the equity market

Question 1

What is equity risk premium?

Answer 1

Excess return that an individual stock or the overall stock market provides over a risk-free rate

-Compensates investors for taking on the relatively higher risk of the equity market

Question 2

What is an example of equity risk premium?

Answer 2

If the return on a stock is 15% and the risk-free rate over the same period is 7%, the equity-risk premium would be 8% (15%-7%) for this stock over that period of time

Question 3

Risk averse and risk seeking percentage of stocks in portfolio

Answer 3

Less risk averse investors would be tempted to hold a higher percentage of stocks in their portfolio

More risk averse ones would assign heavier weights to risk-free instruments (e.g. bonds, money market)

Question 4

Dimson et al (2006) in relation to global ERP

Answer 4

Analyse 106-year period

Estimate ERP for 17 countries and a world index

Question 5

Results of Dimson et al

Answer 5

Relative to short-term T-bills
Equity risk premium was 5.5% for the United States and 4.4% for the United Kingdom.
For the world index, the annualised equity risk premium was 4.7%

-Relative to long-term bonds
Equity risk premium was 4.5% for the United States and 4% for the United Kingdom.
For the world index, the annualised equity risk premium was 4%.

Question 6

Engsted (1998) ERP

Answer 6

Engsted (1998) finds that the equity premium in UK is not as severe as that in US.

Question 7

Mehra and Prescott (1985)

Answer 7

ERP approx 6.9%

-High equity risk premium cannot be reconciled with plausible levels of investors’ risk aversion within a standard paradigm of expected utility maximization

A reasonable level of risk aversion would lead to an ERP of 0.1%.
Estimate coefficient of relative risk aversion >30 needed to explain ERP

Question 8

What are some non-behavioural explanations for ERP?

Answer 8

-Survivorship bias: 36 national stocks beginning of the 20th century, more than half suffered a major break in trading. By only lo oking at the markets with continuous trading histories causes upward biases

Question 9

Bernartzi and Thaler (1995) in relation to ERP

Answer 9

Loss aversion
Slope of the utility function greater for losses than gains
“Losses loom larger than gains”

Mental accounting
Separating blocks of information into more manageable
pieces
How people aggregate information has an effect on how the information is evaluated