The theory of equity premium puzzle explains the scenario of abnormally high historical stock returns over the bonds that are offered by government. The equity premium that is obtained by subtracting bond returns from equity returns is believed to represent the risk difference between the stocks and government bonds, as the government bonds are considered as risk-free.
But it has been seen that the large stock return, which is unexpected in nature, actually develops a tendency of risk aversion amongst the investors and here lies the phenomenon of puzzle. The term ‘equity premium puzzle’ was first introduced by Edward C. Prescott and Rajnish Mehra to refer to this phenomenon.
The equity premium puzzle is believed to be an enigma to the academics of finance and economics. Some academics of finance believe that the equity premium should always be smaller than 6%, which is the historic average.
This is because they think that the difference of returns is huge and it does not represent the proper compensation level occurring due to the risk aversion of the investors. Equity Premium puzzle has enjoyed a number of researches carried out in both the fields of finance and macroeconomics.
After numerous explanations and reasoning presented by the economists, the puzzle still remains elusive. The equity premium puzzle is also believed to be a statistical illusion and it remains unexplained.
- Some classes of explanations of equity premium puzzle are:
Market failure Explanations
Some of the implications of the large equity premium existence given by Quiggin and Grant in 2005 are listed below:
The variability of macroeconomics that is related to recession is expensive.
The executives of the corporate world are under huge pressure in making the myopic decisions.
That risk associated to the corporate profits actually decreases the value of stock market.
The policies like costly reform and disinflation that ensure for a long-term profit at the cost of sho
rt-term inconvenience actually do not attract the investors if the benefits offered by them are risky in nature.
Last Updated on : 1st July 2013