Macro-Finance

3. Equity premium puzzle

Dmitry Kuvshinov

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Risky and safe rates
General discount factor:

Rsafe = 1/E(m) RP = −cov(m, R) ∗ Rsafe

C-CAPM + power utility:

1 cov(∆c−γ , R)
R safe
=   RP = −  t+1 
βE ∆c−γ
t+1
−γ
E ∆ct+1

C-CAPM + power utility + log-normal ∆c:

rsafe = ln(Rsafe ) = δ + γE [ln∆c] − 0.5γ 2 σ 2 [ln∆c]

Rrisky = Rsafe + βR,∆c γσ 2 (∆c)

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Sharpe ratio bounds

These risky and safe rate formulas give us a bound on the

Sharpe ratio (return per unit of risk)

Rrisky − Rsafe
S=
σ(Rrisky )

We can calculate these bounds using data on asset

returns and consumption, and see if they are satisfied in
the data

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Sharpe ratio bounds
General case:

cov(m, R) σm
Rrisky − Rsafe = − = −ρm,R σR
E(m) E(m)
 
 Rrisky − Rsafe 
  σm
 ≤
 σR  E(m)

C-CAPM, log-normal ∆c:

Rrisky = Rsafe + βR,∆c γσ 2 (∆c)

Rrisky − Rsafe βR,∆c γσ 2 (∆c) ρR,∆c σR σ 2 (∆c)
= =
σR σR σ(∆c)σR
S = ρR,∆c γσ(∆c)
|S| ≤ γσ(∆ ln c)

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Sharpe ratio bounds in the data

|S| ≤ γσ(∆ ln c)

Need data on: consumption volatility and risk aversion

US 1870–2015: σ(∆ ln c) = 0.034 (3.4% per year)

What is a reasonable γ?

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A thought experiment

Consider the following gamble: I flip a coin and...

Heads: I multiply your lifetime income by 1 million

Tails: I reduce your lifetime income by 10%

Would you accept?

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A thought experiment

Consider the following gamble: I flip a coin and...

Heads: I multiply your lifetime income by 1 million

Tails: I reduce your lifetime income by 10%

Would you accept?

If you do, your γ < 10

What about a 20% reduction? γ < 5

30% reduction? γ < 3

50% reduction? γ < 2

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Back to Sharpe ratio bounds

|S| ≤ γσ(∆ ln c)

σ(∆ ln c) = 0.034; γ = 2

Sharpe ratio bound: S ≤ 0.068

σR ≈ 0.18 (18% per year)

Equity premium bound: Rrisky − Rsafe ≤ 0.012 (1.2% per

year)

Would you invest in this portfolio?

(S = 0.068, σ = 18%, RP = 1.2%)

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Maybe risk aversion is high?

|S| ≤ γσ(∆ ln c)

Suppose γ = 10

Then S = 0.34, RP = 6%

This is close to the data (US Req = 0.08, Rsafe = 0.02,

S = 0.33

But we have been too generous with other assumptions...

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It gets worse 1: correlation

To get our Sharpe ratio bound, we have assumed ρ∆c,R = 1

In reality, stock returns do not co-move perfectly with

consumption (think: Black Monday 1987, flash crash,
COVID)

Let’s go back to a more “unwrapped” formulation:

|S| ≤ |ρ∆c,R | γσ(∆ ln c)

US data: ρ∆c,R ≤ 0.2

This means we need γ ≈ 50

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It gets worse 2: Sharpe ratios

We have assumed that the S & P 500 return gives the

maximum Sharpe ratio

But in reality, S could be higher (think about all the factor

pricing anomalies, small cap stocks, value stocks)

This means we potentially need γ > 50

Implausibly high γ ⇒ puzzle

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It gets worse 3: Decreasing consumption volatility

We have taken σ(∆ ln c) = 0.034

But this covers the whole 1870–2015 sample

In reality, σ(∆ ln c) has fallen sharply over time

The high 3.4% volatility is driven by the 2 World Wars

Whereas returns have been high throughout

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σ(∆ ln c) and Req − Rsafe , US

Consumption volatility Equity risk premium, 10-year average

20
5

15
4
Per cent

Per cent
10
3

5
2

0
-5
1

1870 1905 1940 1975 2010 1870 1905 1940 1975 2010

US post 1950: Req = 0.085 Rsafe = 0.014 σR = 0.17 S =

0.41 σ(∆ ln c) = 0.017

With ρ = 1, need γ > 20. With ρ < 0.2, need γ > 100
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It gets (even) worse 4: Risk-free rate puzzle
Let’s go back to the semi-plausible
γ = 10 ρ = 1 σ(ln∆c) = 0.034 calibration

From the data, we have E(ln∆c) = 0.018 and

σ 2 (ln∆c) = 0.0012

What would the risk-free rate be in this economy?

rsafe = δ + γE [ln∆c] − 0.5γ 2 σ 2 [ln∆c]

= 0.01 + 10 ∗ 0.018 − 0.5 ∗ 102 ∗ 0.0012 = 0.13

So: we have a 13% safe rate and a 19% risky rate. Realistic?

Potential “solution”: negative δ. Not especially realistic

either.
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It gets (even) worse 5: Cross-country differences in
consumption growth
E [ln∆c] = 0.018 for US and 0.013 for UK

Implied real interest rate differential (ignoring impatience

and precautionary saving):

γ (E [ln∆cUS ] − E [ln∆cUK ]) = 10 ∗ 0.005 = 0.05 (5ppts)

Data: rsafe safe

US = 0.021, rUK = 0.011, 1ppt difference

For some country pairs (e.g. US / Denmark), even the

direction is wrong (∆cUS > ∆cDNK and rsafe safe
US < rDNK )

In general, cross-country growth rate differentials are

sizeable; interest rate differentials are not 10x (or 50x, for
larger γ) those differentials
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The equity premium puzzle

Model-implied risk premia are too low

Or: model-implied risk aversion is too high

References: Mehra and Prescott (1985) for equity premium

puzzle; Weil (1989) for risk-free rate puzzle

Related issues: c and Rrisky correlation, higher Sharpe

ratios, declining c volatility, risk-free rate puzzle(s)

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Discussion

1 Why is there a puzzle?

2 What can be done to fix it?

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The equity premium puzzle: what’s next?

|S| ≤ |ρ∆c,R | γσ(∆ ln c)

The model often gets the direction/intuition right...

Stocks have positive risk premia over bonds, and

co-move positively with consumption
More macro risk, risk aversion or rho (beta) should
mean higher risk premia
Fits recent trends in risky and safe rates

... but gets the magnitudes wrong

Ultimately consumption is just not volatile enough to

generate observed risk premia

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The equity premium puzzle: review

|S| ≤ |ρ∆c,R | γσ(∆ ln c)

Ultimately consumption is just not volatile enough to

generate observed risk premia

Efforts to resolve the puzzle through

1 Different data: reduce S or increase σc (this lecture)

2 Small tweaks: increase ∆m for a given ∆c (after the
volatility puzzle)
3 Major overhaul: completely different variable for m
(bank leverage, behavioural bias...) (end of Part I)

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Different data

|S| ≤ |ρ∆c,R | γσ(∆ ln c)

We want to reduce S; increase σc and ρ

Where to look?

1 Different countries (not US): S and c, maybe ρ

2 Different assets (housing): S
3 Different investors: c
4 Different consumption measure: c

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Different countries

Let’s look at the following data:

17 advanced economies

1870–2015

Many “disaster” events: world wars, revolutions, crises

(sovereign and banking)

References: Dimson, Marsh, and Staunton (2009), Jordà,

Knoll, Kuvshinov, Schularick, and Taylor (2019a), Jordà,
Schularick, and Taylor (2019b), Barro and Ursua (2008)

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Equity premia: 17 countries, 1870–2015

Mean real return, % Standard deviation, %

Equity Equity

Bonds Bonds

Bills Bills

0 2 4 6 8 0 5 10 15 20

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Equity risk premia by country, 1870–2015

Country Risk premium level, % Standard deviation, %

Finland 10.1 31.1
Japan 9.6 27.0
Germany 8.3 27.5
Netherlands 6.6 22.9
Average 6.4 22.2
Australia 6.4 16.0
Canada 6.3 17.3
USA 6.3 18.4
Sweden 6.3 20.2
Italy 6.3 29.7
Spain 6.2 21.1
UK 6.0 19.4
Belgium 5.9 23.1
Portugal 5.4 26.6
Switzerland 4.9 17.4
Denmark 4.9 18.0
Norway 4.9 20.0
France 4.4 21.9
World Portfolio 6.2 13.3
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Equity risk premia through time
10-year MA of cross-country mean, 17 countries
15
10
Per cent
5
0

1870 1905 1940 1975 2010

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Going even further back...
Netherlands, UK and US real equity return: 1630–2015 (Golez and Koudijs,
2018)
20
15 10
Per cent
5 0
-5

1620 1660 1700 1740 1780 1820 1860 1900 1940 1980 2020

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Note I: geometric vs arithmetic means

What is the difference between the two?

When would you use one and not the other?

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Note I: geometric vs arithmetic means
Arithmetic mean (typical return in a random year):
" #
X
rarith = r(t) /T
t
But: if r(1) = +100 and r(2) = −50, rarith = +25

Geometric mean (average cumulative return):

" #1
Y T
rgeo = (1 + r(t)) −1
t

rarith ≥ rgeo ; large variance and large negative returns

increase the difference

Logs give you an approximation:

" #
X
rarith, log = ln(1 + r(t)) /T ≈ rgeo
t
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Equity risk premia by country and averaging method,
1870–2015
Country Arithmetic mean, % Geometric mean, %
Finland 10.1 6.3
Japan 9.6 6.5
Germany 8.3 5.2
Netherlands 6.6 4.4
Average 6.4 4.6
Australia 6.4 5.1
Canada 6.3 4.8
USA 6.3 4.6
Sweden 6.3 4.3
Italy 6.3 2.6
Spain 6.2 4.1
UK 6.0 4.4
Belgium 5.9 3.5
Portugal 5.4 2.4
Switzerland 4.9 3.5
Denmark 4.9 3.4
Norway 4.9 3.0
France 4.4 2.2
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Note II: importance of dividends

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Consumption volatility in different countries

Average sigma = 0.052

.08
.06
.04
.02
0
BR

SA

T
AN

N
EU

P
LD

L
BE
PR
IT

SW

N
AU

H
FR

ES
O

FI
JP

N
U
G

C
N

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17-country consumption volatility over time

Annual consumption volatility Quarterly GDP volatility

10

Median Median
IQ range IQ range

1.5
Linear trend Linear trend
8
Per cent
6

1
4

.5
2
0

0
1880 1905 1930 1955 1980 2005 1950q1 1965q1 1980q1 1995q1 2010q1

US: 3.4% Non-US: 5.5%

US post-1950: 1.7% Non-US post-1950: 2.6%

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 -.25 0 .25 .5 .75 1
FR
A
N
LD
SW
E
IT
A
AU
S
Average rho = 0.086

C
H
E
PR
T
BE
L
ρ∆c,R in different countries

ES
P
N
O
R
U
SA
D
N
K
D
EU
C
AN
G
BR
FI
N
JP
N
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Discussion

Given the cross-country data, do you think the puzzle is

better/worse/resolved - relative to the US case?

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Different countries and time periods: summary

High equity returns across countries and time

But low geometric mean RP in some countries – France &

Portugal

Higher σC outside of US, but low σC recently everywhere

Low ρ seems to be a key barrier to the puzzle

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Different countries: numbers
RP = 2.2 − 6.3%. Average: 4.6%. σR ≈ 22.
World portfolio: σR = 13.

Sharpe ratios: 0.1 − 0.35

ρ :≤ 0.2, average ≤ 0.1 σC : 0.01 − 0.08

Take the most favourable case:

|S| ≤ |ρ∆c,R | γσ(∆ ln c)
0.1 ≤ 0.2 ∗ γ ∗ 0.07 ⇒γ≥7

“Average” case:
0.25 ≤ 0.1 ∗ γ ∗ 0.05 ⇒ γ ≥ 50

Also: don’t forget about the risk-free rate puzzle

Non-US data help, but do not resolve the puzzle

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Other data-related fixes
1 Individual consumption more volatile

Mankiw and Zeldes (1991): consumption of

stockholders more volatile and more correlated with
stock market (i.e. higher ρ and σc )

2 National accounts consumption estimates too smooth

Savov (2011): using garbage to proxy for c reduces γ

by 5x and avoids the risk-free rate puzzle. Still, γ of
18–26
Kroencke (2017) even better results by reversing the
filtering process in NIPA

3 Taxes, transaction costs (McGrattan and Prescott, 2003) –

again lessen the US puzzle
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Other data-related fixes: review

Other fixes: consumption measure (individual; garbage;

unfiltered); taxes & transaction costs

Generally speaking, these reduce but not eliminate the

puzzle. Bring US closer to other countries, and/or the
historical experiences

The puzzle may not be as big as we thought in the 1980s

(γ > 100) but is still there (γ > 10)

Mankiw and Zeldes (1991) begs a related question: if we

try to understand macro & finance connections, is it right
to focus on equities?

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Discussion

What do you think is the most important piece for resolving

the puzzle:

1 Non-US returns

2 Non-US consumption

3 Different consumption measure

4 Taxes / transaction costs

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Why so much focus on equities?
Share of households with non-zero equity wealth
Stock market participation, US

Direct ownership
.6 Direct ownership + Pensions

.4

.2

0
1950 1956 1962 1968 1977 1989 1995 2001 2007 2013

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Composition of wealth in US & Europe
SCF and ECB Household Finance and Consumption Survey, 2016

100

90

80

70

60
Per cent

50

40

30

20

10

Housing Equity Other

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Household wealth in Spain
Martínez-Toledano (2019)

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What is the return to holding real estate?
Phous + Net Renthous
Rhous
t = t t
Phous
t−1

Lots of measurement issues

Constructing economy-wide aggregate measures

Imputing missing housing transactions, and rents for

homeowners

Accounting for depreciation and maintenance costs

Extrapolation using rent and house price indices

Jordà, Knoll, Kuvshinov, Schularick, and Taylor (2019a) do

this + extensive checks. Still, future research will improve
estimates.
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Adding housing to the picture

Full sample Post-1950

Housing Housing

Equity Equity

Bonds Bonds

Bills Bills
0 2 4 6 8 0 2 4 6 8
Mean annual return, per cent Mean annual return, per cent

Bills Excess Return vs Bills Mean Annual Return

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What about the risk?

Real returns Standard deviation

Housing Housing

Equity Equity

Bonds Bonds

Bills Bills

0 2 4 6 8 0 5 10 15 20

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Geometric returns; importance of rents

Equity Housing

Real Dividend Real Real Rental Real

capital income total capital income total
gain return gain return

Mean return p.a. 2.8 4.2 6.8 1.6 5.5 6.9

Standard deviation 21.4 1.7 21.9 9.9 2.0 10.4
Geometric mean 0.6 4.2 4.6 1.1 5.5 6.4
Observations 1707 1707 1707 1707 1707 1707

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Sharpe ratios

Return and Risk Sharpe ratios

12

PRT
ITA
FIN DEU
Mean annual return, per cent

FIN
BEL FRA
9

SWE
DNK USA NOR
NORDEU SWE
AUS
DNK BEL DNK
NLD
FRA DEU ITA
NLD
GBR GBR
JPN
PRT AUS CHE
USA JPNESP NLD
6

CHEGBR NOR
BEL
ITAESP JPN
PRT
FRA ESP
CHE
3

FIN
SWE
USA Equity
Equity Housing
AUS
0

Housing
0 10 20 30 40
Standard Deviation 0 .25 .5 .75 1 1.25

Things to consider: individual houses, transaction costs,

liquidity premia
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 -.25 0 .25 .5 .75 1
FR
A
ES
P
N
Housing: Rho

LD
U
SA
AU
Average rho = 0.23

S
SW
E
C
H
E
IT
A
N
O
R
D
N
K
FI
N
G
BR
PR
T
D
EU
BE
L
JP
N
C
AN
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Housing: discussion / quiz

What would we expect, given the model and ρhous ≥ ρeq ?

Housing has low Sharpe ratio

Housing has similar Sharpe ratio to equity

Housing has higher Sharpe ratio than equity

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Housing: taking stock
Another asset with high Sharpe ratios, another puzzle?

Helps in some ways:

Shows the risk premium puzzle is relevant from a

macro perspective
The model which explains the equity premium would
also predict a high housing premium

Makes things trickier in other ways

Given equity-housing diversification and high Sharpe

ratios, makes the case for high γ very compelling
The risk premium puzzle unlikely to go away with
better data, need to change the model
Before we do this, we’ll look at the volatility puzzle
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References I

Barro, Robert J. and Jose F. Ursua (2008). “Consumption Disasters in the Twentieth
Century”. In: American Economic Review 98.2, pp. 58–63.

Dimson, Elroy, Paul Marsh, and Mike Staunton (2009). Triumph of the Optimists: 101
Years of Global Investment Returns. Princeton, N.J.: Princeton University Press.

Golez, Benjamin and Peter Koudijs (2018). “Four Centuries of Return Predictability”. In:
Journal of Financial Economics 127.2, pp. 248–263.

Jordà, Òscar, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor
(2019a). “The Rate of Return on Everything, 1870–2015”. In: Quarterly Journal of
Economics 134 (3), pp. 1225–1298.

Jordà, Òscar, Moritz Schularick, and Alan M. Taylor (2019b). The Total Risk Premium
Puzzle. NBER Working Paper 25653.

Kroencke, Tim A. (2017). “Asset Pricing without Garbage”. In: Journal of Finance 72.1,
pp. 47–98.

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References II

Mankiw, N. Gregory and Stephen P. Zeldes (1991). “The Consumption of Stockholders

and Nonstockholders”. In: Journal of Financial Economics 29.1, pp. 97–112.

Martínez-Toledano, Clara (2019). House Price Cycles, Wealth Inequality and Portfolio
Reshuffling. Working Paper.

McGrattan, Ellen R. and Edward C. Prescott (2003). “Average Debt and Equity Returns:
Puzzling?” In: American Economic Review: Papers & Proceedings 93.2, pp. 392–397.

Mehra, Rajnish and Edward C. Prescott (1985). “The Equity Premium: A Puzzle”. In:
Journal of Monetary Economics 15.2, pp. 145–161.

Savov, Alexi (2011). “Asset Pricing with Garbage”. In: Journal of Finance 66.1, pp. 177–201.

Weil, Philippe (1989). “The Equity Premium Puzzle and the Risk-free Rate Puzzle”. In:
Journal of Monetary Economics 24.3, pp. 401 –421.

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