Working Paper: NBER ID: w19684
Authors: Efstathios Avdis; Jessica A. Wachter
Abstract: The equity premium, namely the expected return on the aggregate stock market less the government bill rate, is of central importance to the portfolio allocation of individuals, to the investment decisions of firms, and to model calibration and testing. This quantity is usually estimated from the sample average excess return. We propose an alternative estimator, based on maximum likelihood, that takes into account information contained in dividends and prices. Applied to the postwar sample, our method leads to an economically significant reduction from 6.4% to 5.1%. Simulation results show that our method produces tighter estimates under a range of specifications.
Keywords: equity premium; maximum likelihood estimation; financial econometrics
JEL Codes: C32; C58; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| MLE approach (C51) | equity premium (G12) |
| sample average estimate (C13) | equity premium (G12) |
| shocks to dividend-price ratio (G35) | returns (Y60) |
| negative shocks to dividend-price ratio (G35) | positive shocks in returns (G17) |
| MLE (C51) | tighter estimates (C51) |
| MLE (C51) | reliable estimate of equity premium (G12) |
| Monte Carlo simulations (C15) | effectiveness of MLE (C52) |
| GARCH models (C58) | robustness of results (C52) |