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Can rare events explain the equity premium puzzle?

Julliard, Christian and Ghosh, Anisha (2008) Can rare events explain the equity premium puzzle? Discussion paper, 610. Financial Markets Group, London School of Economics and Political Science, London, UK.

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Identification Number: 610

Abstract

Probably not. First, allowing the probabilities attached to the states of the economy to differ from their sample frequencies, the Consumption-CAPM is still rejected by the data and requires a very high level of Relative Risk Aversion(RRA) in order to rationalize the stock market risk premium. This result holds for a variety of data sources and samples –including ones starting as far back as 1890. Second, we elicit the likelihood of observing an Equity Premium Puzzle (EPP) if the data were generated by the rare events probability distribution needed to rationalize the puzzle with a low level of RRA. We find that the historically observed EPP would be very unlikely to arise. Third, we find that the rare events explanation of the EPP signi…cantly worsens the ability of the Consumption-CAPM to explain the cross-section of asset returns. This is due to the fact that, by assigning higher probabilities to bad –economy wide –states in which consumption growth is low and all the assets in the cross-section tend to yield low returns, the rare events hypothesis reduces the cross-sectional dis-persion of consumption risk relative to the cross-sectional variation of average returns

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2008 The Authors
Subjects: H Social Sciences > HB Economic Theory
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Departments > Economics
Collections > LSE Financial Markets Group (FMG) Working Papers
Date Deposited: 09 May 2008 15:50
Last Modified: 27 Feb 2014 15:35
URI: http://eprints.lse.ac.uk/id/eprint/4808

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