Browsing by Subject "equity premium"

The long-run average return on equities shows a sizable premium with respect to their relatively riskless alternatives, the short-run government bonds. The dominant explanation is that the excess return is compensation for rare but severe consumption disasters which result in heavy losses on equities. This thesis studies the plausibility of this explanation in a common theoretical framework. The consumption disasters hypothesis is studied in the conventional Lucas-tree model with two assets and with constant relative risk aversion preferences, captured by the power utility function. The thesis argues that this oft-used model is unable to account for the high premium, and a simulation experiment is conducted to find evidence for the argument. The consumption process is modelled by the threshold autoregressive process, which offers a simple and powerful way to describe the equity premium as a result of a peso problem. Two statistics, the arithmetic average and the standard deviation, are used to estimate the long-run average and the volatility of the returns. The simulated data is analyzed and compared to the real world financial market data. The results confirm that the potential for consumption disasters produces a lower equity premium than the case without disasters in the Lucas-tree model with power utility. The disaster potential lowers the average return on equity instead of increasing it. This result comes from the reciprocal connection between the coefficient of relative risk aversion and the elasticity of intertemporal substitution, and from the special nature of the equity asset, which is a claim on the consumption process itself. The risk-free asset remains unaffected by the disaster potential. The equity premium remains a puzzle in this framework. The advantage of the threshold autoregressive consumption process is to show this result with clarity. Breaking the link between aversion to risk and intertemporal substitution is indeed one possible direction to take. Changing the assumptions about expected consumption or about the equity asset might offer another way forward. Another form of utility or another model is needed if the equity premium is to be explained in financial markets that are free of frictions.