The Total Risk Premium Puzzle

Abstract

The risk premium puzzle is worse than you think. Using a new database for the U.S. and 15 other advanced economies from 1870 to the present that includes housing as well as equity returns (to capture the full risky capital portfolio of the representative agent), standard calculations using returns to total wealth and consumption show that: housing returns in the long run are comparable to those of equities, and yet housing returns have lower volatility and lower covariance with consumption growth than equities. The same applies to a weighted total-wealth portfolio, and over a range of horizons. As a result, the implied risk aversion parameters for housing wealth and total wealth are even larger than those for equities, often by a factor of 2 or more. We find that more exotic models cannot resolve these even bigger puzzles, and we see little role for limited participation, idiosyncratic housing risk, transaction costs, or liquidity premiums.

Measuring distortions in international markets

“…The three largest recipients were Tsinghua Unigroup (USD 3.4 billion), SMIC (USD 695 million), and JCET (USD 688 million), notably for the loans they received from Chinese state banks such as the Bank of China, the China Development Bank, and the China Construction Bank. 85 Hua Hong (USD 71 million) is another firm that obtained support from Chinese state banks, albeit in a lower proportion due to that firm's lower borrowings).…”

“…Calculating the support equivalent of below-market borrowings is far from straightforward, however. There is no internationally recognised method for doing so, with practices differing widely (Jones and Steenblik, 2010 [85]). Consistent with earlier OECD work on the aluminium value chain (OECD, 2019 [1]), this report chooses to compare the actual interest rates charged to firms against a hypothetical benchmark rate of interest that could have been charged in a private market, conditional on borrowers' characteristics.…”

A new approximation for the risk premium with large risks

“…It is used practically in terms of allocating funds among different types of assets, as well as empirically in testing the predictions of and therefore the underpinnings of theoretical models in finance (e.g. Shirvani et al, 2021;Jorda et al, 2019). In some cases the risk premium is instead used to infer the degree of risk aversion of investors (Todter, 2008;Cotter and Hanly, 2010).…”

Financial lessons from the long history of housing markets

“…Their results -based on secondary data sources -suggest that housing returns are surprisingly high given their risk. Indeed, in a follow-up paper, Jordà et al (2019b) point out an unsolved risk premium puzzle for housing investments.…”

“…Across all countries they study, they find geometric returns to housing to be on average 2% higher than returns on equities, but with only half the volatility. In a follow-up paper, Jordà et al (2019b) specifically point to a housing risk premium puzzle.…”