The Equity Premium: It's Still a Puzzle

Abstract

average real return to stocks in United States has been about six percent per year higher than that on Treasury bills. At same time, average real return on Treasury bills has been about one percent per year. In this paper, I discuss and assess various theoretical attempts to explain these two different empirical phenomena: large and low free rate. I show that while there are several plausible explanations for low level of Treasury returns, large equity premium is still largely a mystery to economists. In order to understand why sample means of equity premium and risk free rate represent puzzles, it is useful to review basics of modern asset pricing theory. It is well known that real returns paid by different financial securities may differ considerably, even when averaged over long periods of time. Financial economists typically explain these differences in average returns by attributing them to differences in degree to which a security's return covaries with typical investor's consumption. If this covariance is high, selling off security would greatly reduce variance of typical investor's consumption stream; in equilibrium, investor must be deterred from reducing his risk in this fashion by security's paying a high average return. There is a crucial problem in making this qualitative explanation of cross-sectional differences in asset returns operational: what exactly is the typical investor's consumption? The famous Capital Asset Pricing Model represents one answer to this question: it assumes that typical investor's consumption stream is perfectly correlated with return to stock market. This allows financial analysts to measure risk of a financial security by its covariance with return to stock market (that is, a scaled version of its beta). More recently, Douglas Breeden (1979) and Robert Lucas (1978) described so-called representative agent models of asset returns in which per capita consumption is perfectly correlated with consumption stream of typical investor. (See also

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