Hostname: page-component-78c5997874-g7gxr Total loading time: 0 Render date: 2024-11-15T04:42:31.999Z Has data issue: false hasContentIssue false
  • English
  • Français

Estimating the Equity Premium

Published online by Cambridge University Press:  08 June 2010

R. Glen Donaldson ,
Mark J. Kamstra  and
Lisa A. Kramer
R. Glen Donaldson
Affiliation:
Sauder School of Business, University of British Columbia, 2053 Main Mall, Vancouver, BC V6T 1Z2, Canada. glen.donaldson@sauder.ubc.ca
Mark J. Kamstra
Affiliation:
Schulich School of Business, York University, 4700 Keele St., Toronto, ON M3J 1P3, Canada. mkamstra@yorku.ca
Lisa A. Kramer
Affiliation:
Rotman School of Management, University of Toronto, 105 St. George St., Toronto, ON M5S 3E6, Canada. lisa.kramer@rotman.utoronto.ca
Get access Rights & Permissions [Opens in a new window]

Abstract

Existing empirical research investigating the size of the equity premium has largely consisted of a series of innovations around a common theme: producing a better estimate of the equity premium by using better data or a better estimation technique. The equity premium estimate that emerges from most of this work matches one moment of the data alone: the mean difference between an estimate of the return to holding equity and a risk-free rate. We instead match multiple moments of U.S. market data, exploiting the joint distribution of the dividend yield, return volatility, and realized excess returns, and find that the equity premium lies within 50 basis points of 3.5%, a range much narrower than was achieved in previous studies. Additionally, statistical tests based on the joint distribution of these moments reveal that only those models of the conditional equity premium that embed time variation, breaks, and/or trends are supported by the data. In order to develop the joint distribution of the dividend yield, return volatility, and excess returns, we need a model of price and return fundamentals. We document that even recently developed analytically tractable models that permit autocorrelated dividend growth rates and discount rates impose restrictions that are rejected by the data. We therefore turn to a wider range of models, requiring numerical solution methods and parameter estimation by the simulated method of moments.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 4 , August 2010 , pp. 813 - 846
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Ang, A., and Liu, J.. “A General Affine Earnings Valuation Model.” Review of Accounting Studies, 6 (2001), 397–425.Google Scholar
Ang, A., and Liu, J.. “Risk, Return, and Dividends.” Journal of Financial Economics, 85 (2007), 1–38.CrossRefGoogle Scholar
Bagwell, L. S., and Shoven, J. B.. “Cash Distributions to Shareholders.” Journal of Economic Perspectives, 3 (1989), 129–140.Google Scholar
Bansal, R., and Yaron, A.. “Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles.” Journal of Finance, 59 (2004), 1481–1509.CrossRefGoogle Scholar
Barro, R. J. “Rare Events and the Equity Premium.” NBER Working Paper W11310 (2005).CrossRefGoogle Scholar
Bekaert, G., and Harvey, C. R.. “Time-Varying World Market Integration.” Journal of Finance, 50 (1995), 403–444.Google Scholar
Bonaparte, Y. “The Equity Premium Puzzle: A Reconciliation.” Working Paper, University of Texas (2008).CrossRefGoogle Scholar
Campbell, J. Y., and Shiller, R. J.. “The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors.” Review of Financial Studies, 1 (1988), 195–228.CrossRefGoogle Scholar
Claus, J., and Thomas, J.. “Equity Premia as Low as Three Percent? Evidence from Analysts’ Earnings Forecasts for Domestic and International Stock Markets.” Journal of Finance, 56 (2001), 1629–1666.CrossRefGoogle Scholar
Cochrane, J. H. Asset Pricing. Princeton, NJ: Princeton University Press (2001).Google Scholar
Corradi, V., and Swanson, N. R.. “Bootstrap Specification Tests for Diffusion Processes.” Journal of Econometrics, 124 (2005), 117–148.CrossRefGoogle Scholar
Dimson, E.; Marsh, P.; and Staunton, M.. “The Worldwide Equity Premium: A Smaller Puzzle.” In Handbook of the Equity Risk Premium, Mehra, R., ed. Amsterdam, The Netherlands: Elsevier (2008).Google Scholar
Donaldson, R. G., and Kamstra, M. J.. “A New Dividend Forecasting Procedure That Rejects Bubbles in Asset Prices: The Case of 1929’s Stock Crash.” Review of Financial Studies, 9 (1996), 333–383.CrossRefGoogle Scholar
Duffie, D., and Singleton, K. J.. “Simulated Moments Estimation of Markov Models of Asset Prices.” Econometrica, 61 (1993), 929–952.Google Scholar
Fama, E. F., and French, K. R.. “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay.” Journal of Financial Economics, 60 (2001), 3–43.Google Scholar
Fama, E. F., and French, K. R.. “The Equity Premium.” Journal of Finance, 57 (2002), 637–659.CrossRefGoogle Scholar
Gordon, M. J. The Investment, Financing and Valuation of the Corporation. Homewood, IL: Irwin (1962).Google Scholar
Graham, J. R., and Harvey, C. R.. “The Long-Run Equity Risk Premium.” Finance Research Letters, 2 (2005), 185–194.CrossRefGoogle Scholar
Hannan, E. J. “The Estimation of the Order of an ARMA Process.” Annals of Statistics, 8 (1980), 1071–1081.Google Scholar
Hodrick, R. J. “Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement.” Review of Financial Studies, 5 (1992), 357–386.Google Scholar
Hull, J. C. Options, Futures, and Other Derivative Securities. Englewood Cliffs, NJ: Prentice-Hall (1993).Google Scholar
Jorion, P., and Goetzmann, W. N.. “Global Stock Markets in the Twentieth Century.” Journal of Finance, 54 (1999) 953–980.CrossRefGoogle Scholar
Kendall, M. G., and Stuart, A.. The Advanced Theory of Statistics, Vol. 1, 4th ed.New York, NY: MacMillan Publishing (1977).Google Scholar
Kocherlakota, N. R. “The Equity Premium: It’s Still a Puzzle.” Journal of Economic Literature, 34 (1996), 42–71.Google Scholar
Maheu, J. M., and McCurdy, T. H.. “How Useful Are Historical Data for Forecasting the Long-Run Equity Return Distribution?” Journal of Business and Economic Statistics, 27 (2009), 95–112.Google Scholar
McFadden, D. “A Method of Simulated Moments for Estimation of Discrete Response Models Without Numerical Integration.” Econometrica, 57 (1989), 995–1026.Google Scholar
Mehra, R. “The Equity Premium: Why Is It a Puzzle?” Financial Analysts Journal, 59 (2003), 54–69.CrossRefGoogle Scholar
Mehra, R., and Prescott, E. C.. “The Equity Premium: A Puzzle.” Journal of Monetary Economics, 15 (1985), 145–161.CrossRefGoogle Scholar
Mehra, R., and Prescott, E. C.. “The Equity Premium in Retrospect.” In Handbook of the Economics of Finance, Vol. 1B, Constantinides, G. M., Harris, M., and Stulz, R., eds. Amsterdam, The Netherlands: Elsevier BV (2003).Google Scholar
Merton, R. C. “On Estimating the Expected Return on the Market: An Exploratory Investigation.” Journal of Financial Economics, 8 (1980), 323–361.CrossRefGoogle Scholar
Nelson, D. B. “Conditional Heteroskedasticity in Asset Returns: A New Approach.” Econometrica, 59 (1991), 347–370.CrossRefGoogle Scholar
Newey, W. K., and West, K. D.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.Google Scholar
Pakes, A., and Pollard, D.. “Simulation and the Asymptotics of Optimization Estimators.” Econometrica, 57 (1989), 1027–1057.CrossRefGoogle Scholar
Pástor, L., and Stambaugh, R. F.. “The Equity Premium and Structural Breaks.” Journal of Finance, 56 (2001), 1207–1239.CrossRefGoogle Scholar
Rozeff, M. S. “Dividend Yields Are Equity Risk Premiums.” Journal of Portfolio Management, 11 (1984), 68–75.Google Scholar
Shiller, R. J. “Stock Prices and Social Dynamics.” Brookings Papers on Economic Activity, 2 (1984), 457–498.Google Scholar
Siegel, J. J., and Thaler, R. H.. “Anomalies: The Equity Premium Puzzle.” Journal of Economic Perspectives, 11 (1997), 191–200.Google Scholar
Welch, I. “Views of Financial Economists on the Equity Premium and on Professional Controversies.” Journal of Business, 73 (2000), 501–537.Google Scholar
Welch, I. “The Consensus Estimate for the Equity Premium by Academic Financial Economists in December 2007.” Working Paper, Brown University (2008).Google Scholar
White, H. Asymptotic Theory for Econometricians. Orlando, FL: Academic Press (1984).Google Scholar