Working Paper: NBER ID: w12487
Authors: Urban J. Jermann
Abstract: This paper studies the determinants of the equity premium as implied by producers' first-order conditions. A closed form expression is presented for the Sharpe ratio at steady-state as a function of investment volatility and adjustment cost curvature. Calibrated to the U.S. postwar economy, the model can generate a sizeable equity premium, with reasonable volatility for market returns and risk free rates. The market's Sharpe ratio and the market price of risk are very volatile. Contrary to most models, the model generates a negative correlation between conditional means and standard deviations of aggregate excess returns.
Keywords: equity premium; production; investment volatility; adjustment costs
JEL Codes: E23; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investment volatility (G11) | Equity premium (G19) |
| Adjustment cost curvature (D24) | Equity premium (G19) |
| Investment volatility and adjustment cost curvature (G31) | Sharpe ratio (G11) |
| Higher volatility in returns (G17) | Lower expected returns (G19) |
| Sharpe ratio (G11) | Market price of risk (G19) |