List of Contributors ......................................... xvii
Preface ....................................................... xix
Introduction to the Series .................................. xxiii
1 The Equity Premium: ABCs ..................................... 1
Rajnish Mehra (UCSB) and Edward C. Prescott (Arizona State)
1 Introduction .............................................. 2
1.1 An Important Preliminary Issue ....................... 2
1.2 Data Sources ......................................... 3
1.3 Estimates of the Equity Premium ...................... 6
1.4 Variation in the Equity Premium Over Time ............ 9
2 Is the Equity Premium Due to a Premium for Bearing
Non-Diversifiable Risk? .................................. 11
2.1 Standard Preferences ................................ 14
References ............................................... 25
Appendix A ............................................... 29
Appendix В ............................................... 29
Appendix С ............................................... 35
Appendix D ............................................... 35
2 Risk-Based Explanations of the Equity Premium ............... 37
John B. Donaldson (Columbia) and Rajnish Mehra (UCSB)
Introduction ............................................. 39
1 Alternative Preference Structures ........................ 41
1.1 Preliminaries ....................................... 41
1.2 Coincidence of Risk and Time Preferences in CRRA
utility ............................................. 44
1.3 Separating Risk and Time Preferences: Epstein-Zin
and others .......................................... 46
1.4 Variation in the CRRA and EIS ....................... 52
1.5 Habit Formation ..................................... 55
1.6 Behavioral Models ................................... 61
1.7 Beyond One Good and a Representative Agent .......... 71
2 Production Economies ..................................... 78
3 Disaster Events and Survivorship Bias .................... 81
4 Market Incompleteness and Trading Frictions .............. 86
4.1 Restricted Participation ............................ 86
5 Model Uncertainty ........................................ 91
6 Concluding Comments ...................................... 93
References ............................................... 94
3 Non-Risk-based Explanations of the Equity Premium ......... 101
Rajnish Mehra (UCSB) and Edward C. Prescott (Arizona State)
Introduction ............................................ 102
1 The Inappropriateness of Using T-Bills as a Proxy for
the Intertemporal Marginal Rate of Substitution
Consumption ............................................. 102
1.1 Liquidity .......................................... 104
1.2 Transaction Balances ............................... 104
2 The Effect of Government Regulations and Rules .......... 106
3 Taxes ................................................... 107
4 Borrowing Constraints ................................... 110
5 The Impact of Agent Heterogeneity and Intermediation
Costs ................................................... 113
6 Concluding Comments ..................................... 114
References .............................................. 114
4 Equity Premia with Benchmark Levels of Consumption:
Closed-Form Results ........................................ 117
Andrew B. Abel (Wharton)
1 Preferences ............................................. 120
2 The Canonical Asset ..................................... 126
2.1 The Price of the Canonical Asset ................... 127
2.2 The Rate of Return on the Canonical Asset .......... 129
3 Risk, Term, and Equity Premia ........................... 131
4 Log-Normality ........................................... 134
5 Risk, Term, and Equity Premia Under Log-Normality with
Consumption Externalities and Without Habit Formation ... 135
6 Linear Approximations to Risk, Term, and Equity Premia .. 137
7 Second Moments .......................................... 138
7.1 Linear Approximations to Second Moments ............ 140
8 Correlation of Dividend-Price Ratio and the Rate of
Return on Stock ......................................... 142
8.1 Correlation of Dividend-Price Ratio and the
Excess Rate of Return on Stock ..................... 144
9 Special Cases ........................................... 146
9.1 Rational Expectations .............................. 146
9.2 Distorted Beliefs .................................. 151
10 Accuracy of Approximations .............................. 153
11 Summary ................................................. 156
References .............................................. 156
Discussion: Francisco Gomes (LBS) .......................... 158
1 Introduction ............................................ 158
2 Preferences with Benchmark Levels of Consumption ........ 159
3 Changing the "Benchmark Level" of the Explanation ....... 161
3.1 Aggregate Moments .................................. 161
3.2 Micro-Economic Implications ........................ 162
3.3 Micro-Economic Foundations and Aggregation ......... 163
4 Leverage, Correlation between Dividends and
Consumption, and distorted Beliefs ...................... 163
4.1 Levered Equity Claims and Correlation Between
Dividends and Consumption .......................... 163
4.2 Non-Rational Expectations .......................... 164
5 Final Remarks ........................................... 165
References .............................................. 165
5 Long-Run Risks and Risk Compensation in Equity Markets ..... 167
Ravi Bansal (Duke)
1 Introduction ............................................ 168
2 Long-Run Risks Model .................................... 170
2.1 Preferences and the Environment .................... 170
2.2 Long-Run Growth Rate Risks ......................... 171
2.3 Long-Run Growth and Uncertainty Risks .............. 174
2.4 Data and Model Implications ........................ 176
3 Cross-Sectional Implications ............................ 185
3.1 Value, Momentum, Size, and the Cross-Sectional
Puzzle ............................................. 185
4 Conclusion .............................................. 191
References .............................................. 191
Discussion: John C. Heaton (Chicago) ....................... 194
1 Summary ................................................. 194
2 A Low-Frequency Component in Consumption? ............... 194
3 Preferences ............................................. 195
4 Returns and Long-Run Cash Flows ......................... 197
5 Conclusion .............................................. 198
References .............................................. 198
6 The Loss Aversion/Narrow Framing Approach to the Equity
Premium Puzzle ............................................. 199
Nicholas Barberis (Yale) and Ming Huang (Cornell)
1 Introduction ............................................ 201
2 Loss Aversion and Narrow Framing ........................ 203
3 The Equity Premium ...................................... 207
3.1 Modeling Loss Aversion and Narrow Framing .......... 207
3.2 Quantitative Implications .......................... 212
3.3 Attitudes to Large Monetary Gambles ................ 216
3.4 Attitudes to Small Monetary Gambles ................ 218
3.5 The Importance of Narrow Framing ................... 220
4 Other Applications ...................................... 224
5 Further Extensions ...................................... 225
5.1 Dynamic Aspects of Loss Aversion ................... 225
5.2 Other Forms of Narrow Framing ...................... 226
6 Conclusion and Future Directions, ....................... 227
References .............................................. 228
Discussion: Xavier Gabaix (New York) ....................... 230
1 Work Out More Systematically the Preferences of PT
vs. EU Investors—The "Equity Protection Puzzle" ......... 230
2 Make Quantitative Predictions, Particularly About
Equilibrium Market Phenomena, Rather than Just about
Individual Trading Behavior ............................. 232
3 Do a Version of the Model in Continuous Time ............ 233
References .............................................. 234
Discussion: Ravi Jagannathan (Northwestern) ............. 235
7 Financial Markets and the Real Economy ..................... 237
John H. Cochrane (Chicago)
1 Introduction ............................................ 239
1.1 Risk Premia ........................................ 239
1.2 Who Cares? ......................................... 242
1.3 The Mimicking Portfolio Theorem and the Division
of Labor ........................................... 243
2 Facts: Time Variation and Business Cycle Correlation
of Expected Returns ..................................... 244
2.1 Variation over Time ................................ 244
2.2 Variation Across Assets ............................ 245
2.3 Return Forecasts—Variation over Time ............... 246
2.4 The Cross Section of Returns—Variation Across
Assets ............................................. 251
3 Equity Premium .......................................... 257
3.1 Mehra and Prescott and the Puzzle .................. 261
3.2 The Future of the Equity Premium ................... 266
4 Consumption Models ...................................... 267
4.1 Hansen and Singleton; Power Utility ................ 267
4.2 New Utility Functions .............................. 270
4.3 Empirics with New Utility Functions ................ 273
4.4 Consumption and Factor Models ...................... 286
5 Production, Investment, and General Equilibrium ......... 290
5.1 "Production-Based Asset Pricing" ................... 290
5.2 General Equilibrium ................................ 294
6 Labor Income and Idiosyncratic Risk ..................... 302
6.1 Labor and Outside Income ........................... 302
6.2 Idiosyncratic Risk, Stockholding, and Micro Data ... 307
7 Challenges for the Future ............................... 314
References .............................................. 314
Appendix ................................................ 322
Discussion: Lars Peter Hansen (Chicago) ................. 326
References .............................................. 329
8 Understanding the Equity Risk Premium Puzzle ............... 331
George M. Constantinides (Chicago)
1 Introduction ............................................ 332
2 Habit Persistence ....................................... 337
3 Limited Stock Market Participation and Per Capita
Consumption ............................................. 345
4 Incomplete Markets and Idiosyncratic Income Shocks ...... 349
5 Concluding Remarks ...................................... 355
References .............................................. 356
Discussion: Hanno Lustig (UCLA) ............................ 360
1 Introduction ............................................ 360
1.1 Environment ........................................ 361
1.2 Preferences and Endowments ......................... 361
2 Complete Markets ........................................ 362
2.1 Equilibrium ........................................ 363
2.2 Equity Premium Puzzle .............................. 364
3 Missing Markets ......................................... 364
3.1 Equilibrium ........................................ 365
3.2 Mankiw's Recipe for Generating Risk Premia ......... 365
3.3 Constantinides and Duffie .......................... 366
3.4 Independence of Idiosyncratic Shocks from
Aggregate Conditions ............................... 368
4 Missing Markets and State-Dependent Solvency
Constraints ............................................. 370
4.1 Incomplete Markets ................................. 370
4.2 Complete Markets ................................... 371
5 Conclusion .............................................. 372
References .............................................. 372
A Second-Order Taylor Expansion ........................ 373
B Constantinides and Duffie ............................ 374
9 Cash Flow Risk, Discounting Risk, and the Equity Premium
Puzzle ..................................................... 377
Gurdip Bakshi (Maryland) and Zhiwu Chen (Yale)
1 Introduction ............................................ 379
2 Economic Determinants of Equity Premium ................. 381
2.1 Cash Flow Process .................................. 381
2.2 The Discounting Process ............................ 382
2.3 Dynamics of the Market Portfolio ................... 383
2.4 Dynamics of the Equity Premium ..................... 385
3 Time-Series Data on S&P500 EPS, EPS Growth, and the
Interest Rate ........................................... 387
4 Implications of the Model for Equity Premium ............ 389
4.1 How Large Is the Interest-Rate Risk Premium? ....... 389
4.2 Maximum-Likelihood Estimation of the (Physical)
G. Process ......................................... 391
4.3 Compensation for Cash Flow Risk and the Equity
Premium ............................................ 392
5 Concluding Remarks and Extensions ....................... 396
Appendix ................................................ 398
References .............................................. 400
Discussion: Vito D. Gala (LBS) ............................. 403
1 Discussion .............................................. 403
1.1 Calibration and Estimation ......................... 404
1.2 Where Is the Equity Premium Puzzle? ................ 405
References .............................................. 407
Discussion: Lior Menzly (Proxima) .......................... 409
1 Introduction ............................................ 410
2 The Model ............................................... 410
2.1 Pricing Kernel ..................................... 410
2.2 Cash Flow Process .................................. 411
2.3 The Model - Solutions .............................. 411
3 Calibration ............................................. 412
3.1 Calibrating the Model .............................. 412
3.2 Estimation Results ................................. 412
4 Two-Stage Procedure - An Empirical Concern .............. 412
5 Conclusion .............................................. 414
References .............................................. 414
10 Distribution Risk and Equity Returns ....................... 415
Jean-Pierre Danthine (Lausanne), John B. Donaldson
(Columbia), and Paolo Siconolfi (Columbia)
1 Introduction ............................................ 417
2 The Business Cycle and the Labor Market ................. 418
2.1 The Stylized Facts of the Business Cycle ........... 418
2.2 The Labor Market ................................... 421
3 The Model Economy ....................................... 423
3.1 Workers ............................................ 423
3.2 Shareholders ....................................... 424
3.3 The Firm ........................................... 425
3.4 Equilibrium ........................................ 427
3.5 Numerical Procedures and Calibration ............... 429
4 An Economy with Distribution Risk Only .................. 430
5 Adding Aggregate Uncertainty ............................ 432
6 Comparative Dynamics and Welfare Assessment ............. 436
6.1 Changes in the Correlation of Productivity and
Distribution Shocks ................................ 437
6.2 Changes in Risk Aversion and the Conditional Mean
Distribution Shock ................................. 438
6.3 Other Comparative Dynamic Tests .................... 440
6.4 Welfare Considerations ............................. 441
6.5 Explaining the Market Value to National Income
Ratio .............................................. 442
7 Technology-Driven Variations in Factor Shares ........... 443
8 Robustness .............................................. 446
9 An Alternative Interpretation of the Sharing Mechanism .. 448
10 Related Literature ...................................... 452
11 Concluding Comments ..................................... 459
References .............................................. 460
Discussion: Urban J. Jermann (Wharton) ..................... 463
References ................................................. 466
11 The Worldwide Equity Premium: A Smaller Puzzle ............. 467
Elroy Dimson (LBS), Paul Marsh (LBS), and Mike Stauhton (LBS)
1 Introduction ............................................ 469
2 Prior Estimates of the Equity Premium ................... 471
2.1 Expert Opinion ..................................... 472
3 Long-Run International Data ............................. 474
3.1 The DMS Global Database: Composition and Start
Date ............................................... 475
3.2 The DMS Global Database: General Methodology and
Guiding Principles ................................. 477
4 Long-Run Historical Rates of Return ..................... 479
4.1 Extremes of History ................................ 480
4.2 The Long-Run Perspective ........................... 483
5 New Global Evidence on the Equity Premium ............... 486
5.1 The Equity Premium Around the World ................ 487
5.2 A Smaller Risk Premium ............................. 489
5.3 Survivorship of Markets ............................ 490
5.4 Survivorship Bias Is Negligible .................... 492
6 Decomposing the Historical Equity Premium ............... 493
6.1 Unanticipated Success .............................. 493
6.2 Decomposition of the Equity Premium ................ 495
6.3 From the Past to the Future ........................ 497
7 Conclusion .............................................. 500
References .............................................. 501
Appendix 1: Decomposition of the Equity Premium ......... 505
Appendix 2: Data Sources for the DMS Database ........... 507
12 History and the Equity Risk Premium ........................ 515
William N. Goetzmann (Yale) and Roger G. Ibbotson (Yale)
1 Introduction ............................................ 516
2 Historical Conception and Measurement of the Equity
Risk Premium ............................................ 517
3 Stocks, Bonds, Bills, and Inflation ..................... 521
4 History as Written by the Winners? ...................... 523
5 The Equity Premium Over the Very Long Term .............. 524
6 Conclusion .............................................. 527
References .............................................. 528
Discussion: Stephen F. LeRoy (UCSB) ..................... 530
References .............................................. 534
13 Can Heterogeneity, Undiversified Risk, and Trading
Frictions Solve the Equity Premium Puzzle .................. 535
John C. Heaton (Chicago) and Deborah Lucas (Northwestern)
1 Introduction ............................................ 537
2 Labor Income as Background Risk ......................... 539
2.1 Calibrating the Income Process ..................... 544
2.2 Adding Trading Frictions ........................... 547
3 Entrepreneurial Income as Background Risk ............... 552
4 Limited Participation and Limited Diversification ....... 555
5 Conclusions ............................................. 556
References .............................................. 556
Discussion: Kjetil Storesletten (U Oslo) ................... 558
1 Introduction ............................................ 558
2 Labor Income Risk ....................................... 559
3 Transaction Costs ....................................... 560
4 Concentrating Aggregate Risk on Fewer Hands ............. 560
4.1 Entrepreneurial Risk ............................... 560
4.2 Limited Participation .............................. 561
5 Conclusion .............................................. 562
References .............................................. 563
14 Asset Prices and Intergenerational Risk Sharing: The Role
of Idiosyncratic Earnings Shocks ........................... 565
Kjetil Storesletten (U Oslo), Chris Telmer (CMU), and
Amir Yaron (Wharton)
1 Introduction ............................................ 567
2 An Analytical Example of the Constantinides-Duffie
Model ................................................... 569
2.1 Calibration of the Constantinides-Duffie Economy ... 570
2.2 Model Implications ................................. 571
3 Incorporating the Life Cycle ............................ 573
3.1 Calibration ........................................ 576
4 Quantitative Results .................................... 577
4.1 Asset Pricing Implications ......................... 580
4.2 Sensitivity Analysis ............................... 581
5 Conclusions ............................................. 581
References .............................................. 584
A Calibration Appendix ................................. 587
B Asset Pricing ........................................ 590
Discussion: Darrell Duffie (Stanford) ................... 591
References .............................................. 592
Index ......................................................... 593
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