Equity Premium in Efficient Markets

Kausik, B.N. (2023): Equity Premium in Efficient Markets.

Abstract

Equity premium, the surplus returns of stocks over bonds, has been an enduring puzzle. While numerous prior works approach the problem assuming the utility of money is invariant across contexts, our approach implies that in efficient markets the utility of money is polymorphic, with risk aversion dependent on the information available in each context, i.e. the discount on each future cash flow depends on all information available on that cash flow. Specifically, we prove that in efficient markets, informed investors maximize return on volatility by being risk-neutral with riskless bonds, and risk-averse with equities, thereby resolving the puzzle. We validate our results on historical data with surprising consistency.

• Item Type: MPRA Paper
• Language: English
• Keywords: Equity premium, efficient markets
• Subjects: C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G17 - Financial Forecasting and Simulation

References

Mehra, Rajnish, and Edward C. Prescott. "The equity premium: A puzzle." Journal of monetary Economics 15.2 (1985): 145-161.

Arrow, K. J.; Debreu, G. (1954). "Existence of an equilibrium for a competitive economy". Econometrica. 22 (3): 265–290.

Duarte, F., & Rosa, C. (2015). The equity risk premium: a review of models. Economic Policy Review, (2), 39-57.

Mehra, Rajnish. "The equity premium puzzle: a review." Foundations and Trends in Finance 2.1 (2007): 1-81.

Siegel, Laurence B. "The equity risk premium: A contextual literature review." (2017).

Brown, Stephen J., William N. Goetzmann, and Stephen A. Ross. "Survival." The Journal of Finance 50.3 (1995): 853-873.

Dimson, Elroy, Paul Marsh, and Mike Staunton. 2008. “The Worldwide Equity Premium: A Smaller Puzzle.” In Handbook of the Equity Risk Premium. Edited by Rajnish Mehra. Amsterdam: Elsevier.

McGrattan, Ellen R., and Edward C. Prescott. 2001. “Taxes, Regulations, and Asset Prices.” NBER Working Paper 8623 (December): http://www.nber.org/papers/w8623.pdf.

Bernstein, Peter L. "What rate of return can you reasonably expect… or what can the long run tell us about the short run?." Financial Analysts Journal 53.2 (1997): 20-28.

Fama, Eugene F., and Kenneth R. French. "The equity premium." The Journal of Finance 57.2 (2002): 637-659.

Rietz, Thomas A. "The equity risk premium a solution." Journal of monetary Economics 22.1 (1988): 117-131.

Barro, Robert J. "Rare events and the equity premium." (2005). https://www.nber.org/papers/w11310

Benartzi, Shlomo, and Richard H. Thaler. "Myopic loss aversion and the equity premium puzzle." The quarterly journal of Economics 110.1 (1995): 73-92.

Barberis, Nicholas, Ming Huang, and Tano Santos. "Prospect theory and asset prices." The quarterly journal of economics 116.1 (2001): 1-53.

Barberis, Nicholas C., and Ming Huang. "The loss aversion/narrow framing approach to the equity premium puzzle." (2006). In Handbook of the Equity Risk Premium. Edited by Rajnish Mehra. Amsterdam: Elsevier.

Constantinides, George M. "Habit formation: A resolution of the equity premium puzzle." Journal of political Economy 98.3 (1990): 519-543.

Markowitz, H.M. (1952). "Portfolio Selection". The Journal of Finance. 7 (1): 77–91.

Arrow, Kenneth Joseph. Essays in the theory of risk-bearing. Vol. 121. Amsterdam: North-Holland, 1974.

Kydland, Finn E., and Edward C. Prescott. "Time to build and aggregate fluctuations." Econometrica: Journal of the Econometric Society (1982): 1345-1370.

Hildreth, Clifford, and Glenn J. Knowles. Some estimates of Farmers' utility functions. No. 1684-2016-137060. 1982.

Evans, David J. "The elasticity of marginal utility of consumption: estimates for 20 OECD countries." Fiscal studies 26.2 (2005): 197-224.

Groom, Ben, and David Maddison Pr. "New estimates of the elasticity of marginal utility for the UK." Environmental and Resource Economics 72.4 (2019): 1155-1182.

Damodaran, A, 2023. https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm

FRED, 2023a, Inflation, consumer prices for the United States (FPCPITOTLZGUSA).

FRED, 2023b, Real personal consumption expenditures per capita: Services (A797RX0Q048SBEA).

FRED, 2023c, Real personal consumption expenditures per capita: Goods: Nondurable goods (A796RX0Q048SBEA)