Working Paper: CEPR ID: DP4070
Authors: Michael R. Wickens
Abstract: Surprisingly there are very few estimates of the equity risk premium period-by-period that satisfy a no-arbitrage condition, despite the vast literature on the subject. This is mainly due to the difficulties of estimation. Using the stochastic discount factor (SDF) model based on observable macroeconomic factors - as opposed to unobservable (latent) affine factors - and a new econometric methodology, we provide new estimates of the equity risk premium for the US and the UK based on monthly data 1975-2001. We obtain estimates of the risk premium for many of the best-known versions of consumption CAPM including time-separable power utility and time-nonseparable Epstein-Zin utility. We also show why many of the formulations of these models are unable to provide estimates of the risk premium. A related, and rapidly growing, literature that adopts a more statistical approach focuses on the empirical relation between the return on equity (or the Sharpe ratio) and return volatility. We argue that SDF theory implies that this relation is misconceived.
Keywords: Consumption CAPM; Epstein-Zin model; Equity risk premium; Multivariate GARCH; No-arbitrage; Stochastic discount factor model
JEL Codes: C32; C51; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| SDF model challenges (C52) | difficulties in estimating the equity risk premium (D81) |
| SDF model based on observable factors (C52) | difficulties in estimating the equity risk premium (D81) |
| existing formulations of consumption-based asset pricing models (G19) | unreliable estimates of the risk premium (D81) |
| SDF theory (C69) | misconception in empirical relationship between equity returns, Sharpe ratio, and return volatility (G17) |
| new econometric methodology (C51) | improved estimates of the equity risk premium (G12) |