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The Equity Premium: Explained by GDP Growth and Consistent with Portfolio Insurance

Author

Listed:
  • Christophe Faugere

    (U at Albany)

  • Julian Van Erlach

    (Bioscosm Inc.)

Abstract

We find that the long-run equity premium is fully explained by GDP growth and that it is consistent with a short-term portfolio insurance motive. We first derive the macroeconomic equivalent of the standard sustainable growth formula to determine the long-run average return on stocks. The average stock market return depends on the GDP/capita growth rate and the retention rate net of share repurchases. Next, we determine the economy’s return on corporate assets and show that the return on corporate debt is related to overall GDP growth. After calibrating key macro economic/finance parameters, we obtain values for expected equity and corporate debt returns that respectively match the S&P 500 and 3- month T-bill historical arithmetic average returns. Our first conclusion is that in the long-run, the equity premium is generated by economic growth. Our second key result is that the equity premium is also closely approximated by the premium paid on a put option to maintain the value of $1 invested in the market when long-term investors wish to insure against downside risk on a year-to-year basis. These results have implications regarding how risk-free debt is priced and about the economy’s capital structure.

Suggested Citation

  • Christophe Faugere & Julian Van Erlach, 2003. "The Equity Premium: Explained by GDP Growth and Consistent with Portfolio Insurance," Finance 0311004, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0311004
    Note: Type of Document - pdf; prepared on Win2000; to print on HP LaserJet 4 plus; pages: 21; figures: None. Pdf document
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    References listed on IDEAS

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    Cited by:

    1. Casper Christophersen & Petr Jakubik, 2014. "Insurance and the Macroeconomic Environment," EIOPA Financial Stability Report - Thematic Articles 1, EIOPA, Risks and Financial Stability Department.

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    More about this item

    Keywords

    Equity Premium; GDP Growth; Corporate Debt; T-Bills; Risk-Free Rate; Downside Risk; Options; Protective Puts; Portfolio Insurance; Total Stock Return.;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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