Nigel Williamson T.

Lee 2008-21650 Rikki Dela Cruz 2006-71387 BA146 Joel Yu The Equity Premium Puzzle Summary Two concepts, one empirical and the other theoretical, that analysts and researchers have yet to reconcile are the origin of what is called the Equity Premium Puzzle. By compiling the United States historical data on returns from the equity market, one will find that the equity market has given an average return that is around 6.9% higher than relatively risk-free debt. On the other hand, quantitative theory suggests that the premium on equity is too high, even for the amount of risk one is exposed to when dealing with equity. The large difference in real returns to the expected return gives us the Equity Premium Puzzle. We emphasize that the puzzle roots from a difference in actual return and quantitative theory because intuitively, it makes sense that equity, given its highly volatile nature, would be required a bigger premium by investors compared to that of debt which has less risk. In contrast, mathematical models has so far failed to explain the puzzle. This is unacceptable because as Rajnish Mehra explained in his 2003 article, The Equity Premium: Why is it a Puzzle, our studies in economics and finance so far has depended on these mathematical models. If these models will not be able to supply a solution, then we would not be able to use them in any other endeavor. As such, the rest of this paper will do the following, we will first demonstrate the derivation of the Capital Asset Pricing Model (CAPM) through the Consumption-CAPM. And then, we will show examples of studies regarding the Equity Premium Puzzle, using both a quantitative and qualitative approach. CAPM from the CCAPM The objective is to derive the Capital Asset Pricing Model (CAPM) from the Consumption-CAPM or CCAPM. To do this, we must start with the utility formula that defines the CCAPM which is given by equation [1]. ( S.t. ) ( ) [1]

Substituting the constraints into the utility function

Getting the first derivative of this function with respect to Z, the number of assets bought ( )( )( ) ( ) [ ( ) [ ( )( )] ( ) ] [ ( )

Now looking at this equation, we can interpret it as the price of assets given by the discounted future payoff. ( ) ( ) The marginal utility can also be called m, or the SDF (Stochastic Discount Factor which have several other names). So we can re-write the above equation simply as, [2] By dividing equation [2] by Po, we restate the equation by representing it with respect to Po or 1 dollar. [3] Now recall that ( ) ( ) ( ) ( ). Using that property for equation [3], we derive ( ) ( ) ( )[ ( ) ( ) ( ) ] ( )

For the next step, recall equation [2]. If it were a risk free asset then the discount factor m would be with Rf being the risk-free rate. So E(m) = ( ) ( ) ( ) ( ( ( ( ( ( ) ) ) ) ( ) ) ( ))

The equation above is the central idea of the Consumption-CAPM where the risk premium given by ( ) is equal to the negative covariance of the marginal utility and the payoff. Simply put, this equation states that the equity premium will be high when consumption is high (and MU is therefore low). In contrast, the premium is low when consumption is low (but MU is high). Now imagine that there is a market portfolio that has a return R which is perfectly negatively correlated with the marginal utility of the consumtion tomorrow ( ). This will give us the following implications ( ( ) ) ( ( ) ) ( ( ) ) ( )

So given we change the previous equation into, ( ) Now using E(R ) and E(X), E(X) ( ) ( ) ( ( ) ) ( ( )) ( ( ) ) ( ( )) ( ( )) ( ) E(R ) ( ) ( ) Combining these two equations by multiplication, ( ) ( ) Recall that ( ( ) ) ( ( ( ( ( ) ) ) ) ( ( )) ( ( ) ) ( ) ( ( )) ( ) ( ( )) ( ) ( ( )) ( ( ) ) ( ( ) ) ( ( )) ( ) ( ( ))

), so the equation above can be simplified and presented as, ( ) ( ) ( ) ( ( ) ( ) ( ) ( ( ) ( ) ( ( ) ) ) )

( ) ( )

Thus giving the CAPM where the expected value of the asset is given by the risk free rate and the risk premium multiplied by the
( ( ) )

( )

( ( )

It is important to take note that the essential difference between the CAPM and CCAPM is the difference in beta. With regards to the CAPM, its beta reflects how a particular asset goes with the fluctuations in the market. On the other hand, the CCAPM takes into account the consumption under an intertemporal horizon.

Studies and Examples of the Puzzle Mehra and Prescotts illustration of the Puzzle To illustrate the puzzle, Mehra and Prescott made a model that compared the returns of the S&P and Tbills. From the Consumtion-CAPM, they made three assumptions to facilitate their example: 1. The growth rate of consumption, xt+1 ct+1/ct is identically and independently distributed (iid) 2. The growth rate of dividends Zt+1 Yt+1 /Yt,, is iid, and 3. (xt , zt ) are jointly lognormally distributed The first step is to use the pricing relationship: [
( ( )
)

] or in Mehras article shown as:

*(

( ( )

[( ( ( ( (
( ( ) )

) ) ) )( ) )

] or

Substituting ( ) , where comes from the representative utility function of an individual: ( ) and measures the curvature of the utility function Now because is homogeneous of degree 1 in Y, Observe that we can factor out If we have then )

or

Dividing by (

) ( )

or

Given that ( ) is the gross rate of return on equity, then it is also true that
( ( ) )

( (

) )

or

Remember that ( )[ (
(

At the same time, the gross return on a riskless asset can be restated as Take note of logarithmic properties:
)

( ( )

( (

) )

Taking the logs of both where: ( ) ( ) ( ) ( ( ( ) ) ) growth rate of consumption The difference of these two equations show that Where ( ) Now if there is the equilibrium such that x = z, we

and

show that

This last equation shows that the premium that we get from equity (the expected equity minus the riskfree rate) is a product of the coefficient of risk aversion and variance of the growth rate of consumption. Now let us say that the variance of the growth rate of consumption is very small, since intuitively, consumption would not have erratic rates of growth over difference periods. Then if that is the case, then the risk aversion of the representative individual would need to be very large to explain the equity premium, which is highly unlikely. And thus, the Equity Premium Puzzle emerges.

Young investor vs Middle-aged investor and Borrowing Constraints An interesting study by Constantinides et al, as explained by Mehra, had both quantitative and qualitative appeal. According to their study, the price of equity (and this its return) is determined by the income of the people buying equity. As such, the buyers were classified into two segments, the young and the middleaged. Young investors has uncertain income--his salary and wages is not absolutely determined, and his income from investments and equity is also uncertain. Furthermore, his consumption both in current periods and future periods will not highly depend or correlate with his equity income since his salary is not predetermined yet. Now since his salary is not determined, this young investor will use equity to hedge against fluctuations of his salary, thus he will not demand a high return on equity. On the other hand, the middle-aged investors will probably already have a set income which would come from pensions and the like. In other words, he will not expect to get any added income from salaries and therefore look to equity income for an increase in his wealth (and consumption). For this investor, equity does not hedge against his salary anymore and consumption is highly correlated to the amount of equity income. Because of this, the middle-aged investor will demand a higher return from equity. Now the high equity premium can be explained by an assumption that the market for equities is controlled by the middle-aged investors, thus giving it a high premium. This comes from high borrowing constraints that stops young investors without the money to buy equity to borrow money and invest. If there were no borrowing constraints, then more people would buy equity buy borrowing which increases bond return. Overall, the equity premium would shrink. Conclusion To cap off our report, we restate the puzzle: attempts on quantitative models have so far fallen short of explaining the large difference in the equity premium. Though intuitively, it makes sense that investors demand a higher premium for the risk they face in dealing with equity, no definite mathematical proof has been produced to explain the premium.