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Is the Ex Ante Risk Premium Always Positive? Further Evidence

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  • Kathleen D. Walsh

    (School of Banking and Finance, University of New South Wales, UNSW, Sydney, NSW 2052.)

Abstract

An implicit assumption of the conditional CAPM is that the ex ante equity risk premium is positive in all states of the world. Studies on US portfolios by Boudoukh, Richardson and Smith (1993) and on world portfolios by Ostdiek (1998) find violations of this assumption. This paper seeks to test the sign of the equity risk premium in the Australian market using two parallel tests. First, the series is examined for the presence of two regimes using a test developed in Bayesian inference. Truncated normal priors are applied to the means in this test to specifically detect means of opposite sign. Once a negative regime is identified in the risk premium, we try to identify it ex ante using the test developed by Boudoukh, Richardson and Smith (1993). This test allows the moments implied by the model to be conditioned on observable information. We were able to reject the null of a single regime in favour of the two-regime model using the regime-switching test. In addition the inequality tests on contemporaneous data rejected the restriction of a positive risk premium.

Suggested Citation

  • Kathleen D. Walsh, 2006. "Is the Ex Ante Risk Premium Always Positive? Further Evidence," Australian Journal of Management, Australian School of Business, vol. 31(1), pages 93-113, June.
    • Handle: RePEc:sae:ausman:v:31:y:2006:i:1:p:93-113
    DOI: 10.1177/031289620603100106
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    References listed on IDEAS

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    1. Gibbons, Michael R. & Ferson, Wayne, 1985. "Testing asset pricing models with changing expectations and an unobservable market portfolio," Journal of Financial Economics, Elsevier, vol. 14(2), pages 217-236, June.
    2. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 33(1), pages 125-132.
    3. Ostdiek, Barbara, 1998. "The world ex ante risk premium: an empirical investigation," Journal of International Money and Finance, Elsevier, vol. 17(6), pages 967-999, December.
    4. Boudoukh, Jacob & Richardson, Matthew & Smith, Tom, 1993. "Is the ex ante risk premium always positive? *1: A new approach to testing conditional asset pricing models," Journal of Financial Economics, Elsevier, vol. 34(3), pages 387-408, December.
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    Cited by:

    1. Gerald Cheang & Carl Chiarella, 2011. "A Modern View on Merton's Jump-Diffusion Model," Research Paper Series 287, Quantitative Finance Research Centre, University of Technology, Sydney.
    2. Ron Guido & Kathleen Walsh, 2005. "Bond Term Premium Analysis in the Presence of Multiple Regimes," International Review of Finance, International Review of Finance Ltd., vol. 5(1‐2), pages 31-54, March.
    3. Christian Gourieroux & Joann Jasiak, 2006. "A Degeneracy in the Analysis of Volatility and Covolatility Effects," Working Papers 2006-30, Center for Research in Economics and Statistics.

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