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The size of the equity premium

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  • Fabio Fornari

    (Banca d�Italia, Economic Research Department)

Abstract

Among the many controversial variables in finance, risk premia stand out for their lack of observability. Measuring premia as the difference between realized returns on risky and risk-free assets has not led to unanimous conclusions about their size, which greatly depends on the length of the sample; in addition, investment allocations or inflation expectations are influenced by the ex-ante values of the risk premia and ex-post returns are, if any, rough approximations of these. Many papers have dealt with this issue, from the initial contribution of Mehra and Prescott (1985) to very recent advances within a bayesian framework of P�stor and Stambaugh (2001). This paper uses conditional variance models as approximations of static and intertemporal capital asset pricing models; the size of the equity premium is assessed for the US both at the market level and, through a conditional version of the three-factor model of Fama and French (1993), at a firm-level. The market premium has had large swings with short-lived peaks over the last 75 years, fluctuating around a mean value of 5 per cent on a yearly basis; this value rises to 6.5 percent when time-varying investment opportunities are allowed for. In periods of economic expansion the expected premium on the equity return is nearly half the value expected in recession, 20 percent less if the Great Depression period is excluded; the cross-sectional dispersion of the firm-level premia as a function of firm�s size is also influenced by the position of the economy within the business cycle.

Suggested Citation

  • Fabio Fornari, 2002. "The size of the equity premium," Temi di discussione (Economic working papers) 447, Bank of Italy, Economic Research and International Relations Area.
  • Handle: RePEc:bdi:wptemi:td_447_02
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    File URL: http://www.bancaditalia.it/pubblicazioni/temi-discussione/2002/2002-0447/tema_447_02.pdf
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    Cited by:

    1. cipollone piero & Anita Guelfi, 2003. "tax credit policy and firms' behaviour: the case of subsidy to open-end labour contract in italy," Temi di discussione (Economic working papers) 471, Bank of Italy, Economic Research and International Relations Area.

    More about this item

    Keywords

    equity premium; garch;

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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