06b Bounds EquityPremium

FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (1)

LECTURE 06: SHARPE RATIO, BONDS, &
THE EQUITY PREMIUM PUZZLE
Markus K. Brunnermeier
Money, Bonds vs. Stocks
$0
$5
$10
$15
$20
$25
$30
$35
$40
$45
$50
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9
7
2
1
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1
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9
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1
1
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1
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1
9
9
0
1
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1
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1
9
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0
0
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2
0
0
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2
0
0
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2
0
1
1
SP500
US 1y Tsy
US 10Y Tsy
Sharpe Ratios and Bounds
Consider a one period security available at date
with payoff
+1
. We have

+1
+1

or

+1

+1
+cov
+1
,
+1

For a given
+1
we let
+1
=
1

+1

Note that
+1
will depend on the choice of

+1
unless there exists a
riskless portfolio

+1
is the return from to +1, typically measurable w.r.t.
+1
. (An
exception is
, which is measurable w.r.t.
, but we stick with

subscript +1.)

Sharpe Ratios and Bounds (ctd.)
Hence

=
1
+1

+1
Expected PV
+ cov
+1
,
+1
Risk Adjustment

Positive correlation with the discount factor adds
value, i.e. decreases required return
in Returns

+1
+1
=

Divide both sides by
and note that
+1
=
+1

+1
+1
= 1
Using
+1
= 1/

+1
, we obtain

+1

+1

+1
= 0
-discounted expected excess return for all assets
is zero.

in Returns
Since

+1

+1

+1
= 0
cov

+1
,
+1

+1

+1

+1

+1

That is, risk premium or expected excess return

+1

+1
=
cov

+1
,
+1

+1

is determined by its covariance with the
stochastic discount factor

Sharpe Ratio
Multiply both sides with portfolio

+1

+1
=
cov

+1
,
+1

+1

+1

+1
=

+1
,
+1

+1

+1

+1

NB: All results also hold for unconditional expectations

Rewritten in terms of Sharpe Ratio = ...

+1

+1

+1
,
+1
=

+1

+1

+1

Hansen-Jagannathan Bound
Since 1,1 we have

+1

+1
sup

+1

+1

+1

Theorem (Hansen-Jagannathan Bound):
The ratio of the standard deviation of a
stochastic discount factor to its mean exceeds
the Sharpe Ratio attained by any portfolio.
Theorem (Hansen-Jagannathan Bound):
The ratio of the standard deviation of a stochastic
discount factor to its mean exceeds the Sharpe
Ratio attained by any portfolio.
Can be used to easy check the viability of a
proposed discount factor
Given a discount factor, this inequality bounds
the available risk-return possibilities
The result also holds conditional on date t info

expected
return
R
f
s
available portfolios
slope s (m) / E[m]
Assuming Expected Utility

0
,
1

0
,
1
=

0
,
1,
U(c
0
,c
1
)
0
=

0
,
1,1
0
, ,

0
,
1,
1
=

0
,
1,1
1,1
, ,

0
,
1,
1,

Stochastic discount factor
=
MRS
=

1

Time-Separable
Digression: if utility is in addition time-separable

0
,
1
=
0
+
1

Then
0
=

0
0
, ,

0
1
=

1,1
1,1
, ,

1,
1,

And
=
1

1,

0
=

1,

0

A simple example
= 2,
1
=
1
2

3 securities with
1
= 1,0 ,
2
= 1,0 ,
3
= 1,1
Let =
1
2
, 1 , =
1
4
=
1
2
1
2
3
4
2
+
1
2
1
3
4
2

Hence,
1
=
1
4
,
2
=
1
2
=
3
=
3
4
and

1
= 4,0 ,
2
= 0,2 ,
3
=
4
3
,
4
3

1
= 2,
2
= 1,
3
=
4
3

Example: Where does SDF come from?
Representative agent with
Endowment: 1 in date 0, (2,1) in date 1
Utility
0
,
1
,
2
=
ln
0
+ln
1,

i.e.
0
,
1,
= ln
0
+ln
1,
(additive) time separable u-
function
=

1
1,2,1

0
1,2,1
=

0
1,1
,

0
1,2
=
1
2
,
1
1
=
1
2
, 1
since endowment=consumption
Low consumption states are high m-states
Risk-neutral probabilities combine true probabilities and
marginal utilities.

Equity Premium Puzzle
Recall
cov ,

Now:
cov
1
,

Recall Hansen-Jaganathan bound

; =
1

Equity Premium Puzzle (ctd.)

Equity Premium Puzzle
high observed Sharpe ratio of stock market indices
low volatility of consumption
) (unrealistically) high level of risk aversion

u u
c
1
c
2
c
1
c
2
Equity Premium or
Low Risk-free Rate Puzzle?
Suppose we allow for sufficiently high risk
aversion s.t.

1

New problem emerges:
Strong force to consumption smooth over time
(low intertemporal elasticity of consumption (IES))
due to concavity of utility function
vNM utility function
smoothing over states = smoothing over time
CRRA gamma = 1/ IES
Model predicts much higher risk-free rate
Equity Premium or
Low Risk-free Rate Puzzle?
Solution:
depart from vNM utility preference representation
Found preference representation that allows split
Risk-aversion
Intertemporal elasticity of substitution

Kreps-Porteus (special case: vNM)
Epstein-Zin (special case: CRRA vNM)
Digression: Preference for the timing of
uncertainty resolution
$100
$100
$100
p
p
$150
$ 25
$150
$ 25
0
Early (late) resolution if W(P
1
,) is convex (concave)
Kreps-Porteus
Do you want to know whether you will get cancer at the age of 55 now?
0

1
,
2
=
1
,
1

1
,
2

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FIN501 Asset Pricing

Lecture 06 Equity Premium Puzzle (1)

will depend on the choice of

, which is measurable w.r.t.

, but we stick with

and note that

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