Handbook of the Equity Risk Premium (eBook)

Front Cover 1
Handbook of the Equity Risk Premium 4
Copyright Page 5
Contents 8
List of Contributors 18
Preface 20
Introduction to the Series 24
Chapter 1. The Equity Premium: ABCs 26
1. Introduction 27
2. Is the Equity Premium Due to a Premium for Bearing Non-Diversifiable Risk? 36
References 50
Appendix A 54
Appendix B 54
Appendix C 60
Appendix D 60
Chapter 2. Risk-Based Explanations of the Equity Premium 62
Introduction 64
1. Alternative Preference Structures 66
2. Production Economies 103
3. Disaster Events and Survivorship Bias 106
4. Market Incompleteness and Trading Frictions 111
5. Model Uncertainty 116
6. Concluding Comments 118
References 119
Chapter 3. Non-Risk-based Explanations of the Equity Premium 126
Introduction 127
1. The Inappropriateness of Using T-Bills as a Proxy for the Intertemporal Marginal Rate of Substitution of Consumption 127
2. The Effect of Government Regulations and Rules 131
3. Taxes 132
4. Borrowing Constraints 135
5. The Impact of Agent Heterogeneity and Intermediation Costs 138
6. Concluding Comments 139
References 139
Chapter 4. Equity Premia with Benchmark Levels of Consumption: Closed-Form Results 142
1. Preferences 145
2. The Canonical Asset 151
3. Risk, Term, and Equity Premia 156
4. Log-Normality 159
5. Risk, Term, and Equity Premia Under Log-Normality with Consumption Externalities and Without Habit Formation 160
6. Linear Approximations to Risk, Term, and Equity Premia 162
7. Second Moments 163
8. Correlation of Dividend-Price Ratio and the Rate of Return on Stock 167
9. Special Cases 171
10. Accuracy of Approximations 178
11. Summary 181
References 181
Discussion: Francisco Gomes (LBS) 183
1. Introduction 183
2. Preferences with Benchmark Levels of Consumption 184
3. Changing the “Benchmark Level” of the Explanation 186
4. Leverage, Correlation between Dividends and Consumption, and distorted Beliefs 188
5. Final Remarks 190
References 190
Chapter 5. Long-Run Risks and Risk Compensation in Equity Markets 192
1. Introduction 193
2. Long-Run Risks Model 195
3. Cross-Sectional Implications 210
4. Conclusion 216
References 216
Discussion: John C. Heaton (Chicago) 219
1. Summary 219
2. A Low-Frequency Component in Consumption? 219
3. Preferences 220
4. Returns and Long-Run Cash Flows 222
5. Conclusion 223
References 223
Chapter 6. The Loss Aversion/Narrow Framing Approach to the Equity Premium Puzzle 224
1. Introduction 226
2. Loss Aversion and Narrow Framing 228
3. The Equity Premium 232
4. Other Applications 249
5. Further Extensions 250
6. Conclusion and Future Directions 252
References 253
Discussion: Xavier Gabaix (New York) 255
1. Work Out More Systematically the Preferences of PT vs. EU Investors—The “Equity Protection Puzzle” 255
2. Make Quantitative Predictions, Particularly About Equilibrium Market Phenomena, Rather than Just about Individual Trading Behavior 257
3. Do a Version of the Model in Continuous Time 258
References 259
Discussion: Ravi Jagannathan (Northwestern) 260
Chapter 7. Financial Markets and the Real Economy 262
1. Introduction 264
2. Facts: Time Variation and Business Cycle Correlation of Expected Returns 269
3. Equity Premium 282
4. Consumption Models 292
5. Production, Investment, and General Equilibrium 315
6. Labor Income and Idiosyncratic Risk 327
7. Challenges for the Future 339
References 339
Appendix 347
Discussion: Lars Peter Hansen (Chicago) 351
References 354
Chapter 8. Understanding the Equity Risk Premium Puzzle 356
1. Introduction 357
2. Habit Persistence 362
3. Limited Stock Market Participation and Per Capita Consumption 370
4. Incomplete Markets and Idiosyncratic Income Shocks 374
5. Concluding Remarks 380
References 381
Discussion: Hanno Lustig (UCLA) 385
1. Introduction 385
2. Complete Markets 387
3. Missing Markets 389
4. Missing Markets and State-Dependent Solvency Constraints 395
5. Conclusion 397
References 397
A. Second-Order Taylor Expansion 398
B. Constantinides and Duffie 399
Chapter 9. Cash Flow Risk, Discounting Risk, and the Equity Premium Puzzle 402
1. Introduction 404
2. Economic Determinants of Equity Premium 406
3. Time-Series Data on S& P500 EPS, EPS Growth, and the Interest Rate
4. Implications of the Model for Equity Premium 414
5. Concluding Remarks and Extensions 421
Appendix 423
References 425
Discussion: Vito D. Gala (LBS) 428
1. Discussion 428
References 432
Discussion: Lior Menzly (Proxima) 434
1. Introduction 435
2. The Model 435
3. Calibration 437
4. Two-Stage Procedure—An Empirical Concern 437
5. Conclusion 439
References 439
Chapter 10. Distribution Risk and Equity Returns 440
1. Introduction 442
2. The Business Cycle and the Labor Market 443
3. The Model Economy 448
4. An Economy with Distribution Risk Only 455
5. Adding Aggregate Uncertainty 457
6. Comparative Dynamics and Welfare Assessment 461
7. Technology-Driven Variations in Factor Shares 468
8. Robustness 471
9. An Alternative Interpretation of the Sharing Mechanism 473
10. Related Literature 477
11. Concluding Comments 484
References 485
Discussion: Urban J. Jermann (Wharton) 488
References 491
Chapter 11. The Worldwide Equity Premium: A Smaller Puzzle 492
1. Introduction 494
2. Prior Estimates of the Equity Premium 496
3. Long-Run International Data 499
4. Long-Run Historical Rates of Return 504
5. New Global Evidence on the Equity Premium 511
6. Decomposing the Historical Equity Premium 518
7. Conclusion 525
References 526
Appendix 1: Decomposition of the Equity Premium 530
Appendix 2: Data Sources for the DMS Database 532
Chapter 12. History and the Equity Risk Premium 540
1. Introduction 541
2. Historical Conception and Measurement of the Equity Risk Premium 542
3. Stocks, Bonds, Bills, and Inflation 546
4. History as Written by the Winners? 548
5. The Equity Premium Over the Very Long Term 549
6. Conclusion 552
References 553
Discussion: Stephen F. LeRoy (UCSB) 555
References 559
Chapter 13. Can Heterogeneity, Undiversified Risk, and Trading Frictions Solve the Equity Premium Puzzle 560
1. Introduction 562
2. Labor Income as Background Risk 564
3. Entrepreneurial Income as Background Risk 577
4. Limited Participation and Limited Diversification 580
5. Conclusions 581
References 581
Discussion: Kjetil Storesletten (U Oslo) 583
1. Introduction 583
2. Labor Income Risk 584
3. Transaction Costs 585
4. Concentrating Aggregate Risk on Fewer Hands 585
5. Conclusion 587
References 588
Chapter 14. Asset Prices and Intergenerational Risk Sharing: The Role of Idiosyncratic Earnings Shocks 590
1. Introduction 592
2. An Analytical Example of the Constantinides–Duffie Model 594
3. Incorporating the Life Cycle 598
4. Quantitative Results 602
5. Conclusions 606
References 609
A. Calibration Appendix 612
B. Asset Pricing 615
Discussion: Darrell Duffie (Stanford) 616
References 617