chance of winning more money and a 50% chance of losing only ten thousand dollars more.While there is no way to prove mathematically that this implies the equity premium isimplausible and ludicrous, one can see from this demonstration that it is self-evident. It would bedifficult, if not impossible, to find an individual who would behave under these conditions in asimilar manner. Thus, if it is hard to find one person, it is certainly impossible to assume that theaverage market participant would behave such as this.From this brief (and relatively rough) anecdote, one can innately see that the equity risk premium is too large to be described using a simple rational investor model. In fact, Mehra andPrescott resolve that the only way to explain or make sense of the equity premium is if thetypical investor is implausibly, and thus unnaturally, averse to risk (Mehra and Prescott 1985).As a result, many economists have attempted to explain and describe the causes of this premium, but as of yet, none have fully succeeded (Kocherlakota 1996). Accordingly, the question of thisstudy is not what accounts for the equity risk premium, or even why it is so large. Rather, thisstudy will attempt to describe the dynamic nature of its level through time.Ever since the advent of Modern Portfolio Theory, it has been widely accepted that the best way to examine an investment in a financial security is not to analyze its historical returnsand deviations, but rather to make estimates of the future behavior of these securities (Fabozzi,Gupta, and Markowitz 2002). That being said, often the best proxy for the future is the performance of the past. Many of the attempts at describing the equity premium puzzle haveconcentrated on predicting the future level of the premium based on forecasted future levels of consumption, return, and risk aversion (Kocherlakota 1996). In contrast, this study will attemptto explain the oscillations of the equity premium as an entity in and of itself rather than as aspread between two unrelated (or related) securities. The central hypothesis of this study is thatthe equity premium has a mean, which is non-stationary as a result of market shocks, and behaves in a constant, predictable manner around that mean after accounting for noise.
The subjects used in this analysis are the New York Stock Exchange (NYSE)aggregate index and the 90-day U.S. Treasury bill. The NYSE aggregate index was selected as a broad market index to track the general movement of the U.S. security prices for an extended period of time. This index has been available for over 100 years and has always represented awide range of diversified industries present and operating within the United States. Unlike someother market indices, it has exhibited somewhat more damped market cyclicality as a result of its broad industry base. The constituents of the index include all equity securities actively traded onthe New York Stock Exchange as of the date of each data measurement. Therefore, asurvivorship bias is not introduced and thus the index is constantly evolving. The value-weightedversion of this market index was chosen so that securities that are larger on the market are thuslarger within the market index and the opposite for small securities.The 90-day U.S. Treasury bill was selected as the representative risk-free rate for severalreasons. Since it is a U.S. Treasury debt instrument, it is backed by the full faith and trust of theUnited States Government. In the financial community, this is seen as the equivalent of defaultrisk-free. Given that this is a fixed maturity, zero coupon 90-day bill, inflation risk is virtuallynonexistent as well. For the purposes of this study, it is assumed that U.S. inflation was relativelyconstant for any 90-day period over the last 100 years. For the few time periods that may haveexhibited more turbulent inflation, it is assumed that these effects are damped in the analysis by a