Movements in the Equity Premium

Blanchard, Olivier; Shiller, Robert J.; Siegel, Jeremy J.

doi:10.2307/2534565

Cited by 203 publications

(149 citation statements)

References 19 publications

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“…The learning process takes a long time because particular transitions occur rarely and therefore take substantial time to learn about. The model equity premium falls as agents learn, in accordance with evidence reported by Blanchard (1993), Jagannathan, McGratten, and Scherbina (2000), Fama and French (2002), DeSantis (2004), and others that the actual equity premium is declining. These authors also emphasize that expected excess stock returns are now lower than historical averages, which is also an implication of our model.…”

Section: Discussionsupporting

confidence: 87%

The market price of risk and the equity premium: A legacy of the Great Depression?

Cogley

Sargent

2008

Journal of Monetary Economics

184

146

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Friedman and Schwartz hypothesized that the Great Depression created exaggerated fears of economic instability. We quantify their idea by using a robustness calculation to shatter a representative consumer's initial confidence in the parameters of a two-state Markov chain that truly governs consumption growth. The assumption that the consumption data come from the true Markov chain and the consumer's use of Bayes' law cause that initial pessimism to wear off. But so long as it persists, the representative consumer's pessimism contributes a volatile multiplicative component to the stochastic discount factor that would be measured by a rational expectation econometrician. We study how this component affects asset prices. We find settings of our parameters that make pessimism wear off slowly enough to allow our model to generate substantial values for the market price of risk and the equity premium.

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Section: Discussionsupporting

confidence: 87%

The market price of risk and the equity premium: A legacy of the Great Depression?

Cogley

Sargent

2008

Journal of Monetary Economics

184

146

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“…He infers the expected equity premium from a dynamic version of the Gordon (1962) growth model. Blanchard (1993) concludes that the equity premium steadily decreased from the early 1950s, with a transitory increase in the 1970s that he attributes to inflationary trends, to a premium around 2-3%. Wadhwani (1999) applies different assumptions for the input variables of the Gordon growth model and then calculates the implied risk premium that justifies the index level of the S &P thinspace500.…”

Section: B What Is the Market Risk Premium?mentioning

confidence: 98%

“…For example in the UK, the Cost of Living Index in 1914 contained just 14 items including candles and corset lacing-a larger fraction of the services and goods consumed was home produced in the early part of the century. Blanchard (1993) chooses a different approach. Instead of looking at a historic period, he computes the equity premium using a forward-looking approach.…”

Section: B What Is the Market Risk Premium?mentioning

confidence: 99%

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Do We Need CAPM for Capital Budgeting?

Jagannathan¹,

Meier²

2002

Financial Management

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The classic rule for making capital budgeting decisions is to take projects with positive Net Present Value (NPV). Consider a project that generates an annual, real cash flow of 100,000 forever, starting one year from now. The initial investment is 1,600,000. To decide whether to invest in this project or not, we discount all future cash flows and subtract the initial investment to get the NPV. The decision rule is then simple: If the NPV is positive, take it; if the NPV is negative, leave it. The current textbooks used in all major MBA courses advise financial managers to calculate the cost of capital based on the Capital Asset Pricing Model (CAPM). The project's cost of capital is the rate investors require to undertake the investment, and we should discount all future cash flows at this rate. The cost of capital in the CAPM equals the riskfree rate plus a risk premium. The CAPM asserts that the only relevant risk measure for a project is it beta. The beta factor times the excess return of the market over the riskfree rate determines the risk premium of the investment.A key input for the CAPM is the excess return of the market over the riskfree rate, the market (equity) risk premium. The common practice has been to use the historical average return over a long period as a measure of what investors expect to earn. As a proxy for the market portfolio, a broad equity market index is applied. For the US the average market risk premium of the S&P 500 was 7.43% during the post-war period, whereas the real riskfree rate (six-month commercial paper) was 2.19%. Assuming that the project beta is 1.0 and the firm is 100% equity financed, the cost of capital is 2.19% + 1 X 7.43% = 9.62% and the NPV of our project is negative:100,000/ 0.0962 -1,600,000 = -560,499. We would decide against investing.However, a new strand of literature starting with Blanchard (1993) takes a forward-looking perspective to determine the market risk premium. Instead of taking an average over a past period, these studies infer the rate that justifies the current stock market index level given the expected dividends or earnings of all companies in the index. The evidence from this literature suggests that the market risk premium has been only about 2-4% during the last two decades, substantially below the average return of 7.43% for 1951-2000. If we take the value of 2.55% as the equity premium, the estimate that Fama and French (2001) obtain, the NPV of the same

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“…This select list of authors includes Fama and French (1988), Campbell and Shiller (1989, Blanchard (1993), Lamont (1998), and Heaton and Lucas (1999). These authors explore dividends and earnings and how they affect the equity premium.…”

Section: Fundamentalsmentioning

confidence: 99%

Dividends, Momentum, and Macroeconomic Variables as Determinants of the US Equity Premium Across Economic Regimes

Malliaris

Bhar²

2011

Review of Behavioral Finance

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The equity premium of the S&P 500 Index is explained in this paper by several variables that can be grouped into fundamental, behavioral and macroeconomic factors. We hypothesize that the statistical significance of these variables changes across economic regimes. The three regimes we consider are the low, medium and high volatility regimes in contrast to previous studies that do not differentiate across economic regimes. Using the three-state Markov switching regime econometric methodology we confirm that the statistical significance of the independent variables representing fundamentals, macroeconomic conditions and a behavioral variable changes across economic regimes. Our findings offer an improved understanding of what moves the equity premium across economic regimes than what we can learn from single-equation estimation. Our results also confirm the significance of momentum as a behavioral variable across all economic regimes.Key Words: Excess stock returns, equity premium, dividends, macroeconomic variables, momentum, Markov regimes. JEL Classification: C22, E44, G12Current Revised Version: February10, 2011. The authors are very grateful to Professor Ravi Jagannathan for a detailed review of an earlier version of this paper that contributed to a substantial improvement of our hypotheses formulation and econometric methodology. We are also thankful to Professor John Doukas for insightful clarifications on the selection of the appropriate behavioral variable. The presentation of this paper in various seminars in the U.S. and Australia has encouraged the authors enrich both the methodology and exposition of the paper. A detailed and constructive referee report has helped the authors to refocus the scope of this research and to enrich the presentation. Special thanks are offered to the anonymous referee and the editor of the Review of Behavioral Finance. Resubmitted to the REVIEW OF BEHAVIORAL FINANCE. This is the latest master copy dated March 25, 2011.This article is Emerald Publishing Limited and permission has been granted for this version to appear in Loyola eCommons. Emerald does not grant permission for this article to be further copied/distributed or hosted elsewhere without the express permission from Emerald Publishing Limited. 2 Dividends, Momentum and Macroeconomic Variables as Determinants of the U.S. Equity Premium Across Economic Regimes AbstractThe equity premium of the S&P 500 Index is explained in this paper by several variables that can be grouped into fundamental, behavioral and macroeconomic factors. We hypothesize that the statistical significance of these variables changes across economic regimes. The three regimes we consider are the low, medium and high volatility regimes in contrast to previous studies that do not differentiate across economic regimes. Using the three-state Markov switching regime econometric methodology we confirm that the statistical significance of the independent variables representing fundamentals, macroeconomic conditions and a behavioral variable chang...

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Movements in the Equity Premium

Cited by 203 publications

References 19 publications

The market price of risk and the equity premium: A legacy of the Great Depression?

The market price of risk and the equity premium: A legacy of the Great Depression?

Do We Need CAPM for Capital Budgeting?

Dividends, Momentum, and Macroeconomic Variables as Determinants of the US Equity Premium Across Economic Regimes

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