The Equity Premium Puzzle and Its Relationship to Economic Indicators

Open Access
Author:
Anderko, William Victor
Area of Honors:
Finance
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • Timothy T Simin, Thesis Supervisor
  • James Alan Miles, Honors Advisor
Keywords:
  • Equity Premium
  • Equity Premium Puzzle
  • Financial Market
  • Stock Market
  • Finance
Abstract:
The equity premium puzzle has been the center of a great debate ever since 1985, when Rajnish Mehra and Edward C. Prescott recognized this phenomenon in the financial markets of the United States. These two men found that the level of risk aversion, according to standard models, necessary for an investor to place their wealth into a risk-free asset is unreasonably high. This suggests that investors should only invest in the riskier asset, stocks, because its return has been greater than the risk bore by the investor. Although their findings have caused a great amount of research on the topic, a clear, widely accepted explanation of their observations has never been achieved. For this reason, the equity premium continues to be a puzzle. This paper first examines whether or not the equity premium puzzle is in fact a phenomenon occurring in the markets. It sides with Mehra and Prescott and claims that there is an equity premium puzzle. It also attempts to use current economic data in order to predict future equity premiums. As the equity premium moves from month to month, having a tool to predict it would be beneficial to any investor with a portfolio that includes equity and risk-free assets.