are171a-appendix9a - Appendix 9A THE HISTORICAL MARKET RISK...

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Unformatted text preview: Appendix 9A THE HISTORICAL MARKET RISK PREMIUM: ‘ THE VERY LONG RUN The data in Chapter 9 indicate that the returns on common stock have historically been much higher than the returns on short-term government securities. This phenomenon has bothered economists, since it is difficult to justify why large numbers of rational investors purchase the lower yielding bills and bonds. In 1985 Mehra and Prescott published a very influential paper that showed that the his- torical returns for common stocks are far too high when compared to the rates of return on short-term government securities.9 They point out that the difference in returns (frequently called the market risk premium for equity) implies a very high degree of risk aversion on the part of investors. Since the publication of the Mehra and Prescott research, financial economists have tried to explain the so—called equity risk premium puzzle. The high his- torical equity risk premium is especially intriguing compared to the very low historical rate of return on Treasury securities. This seems to imply behavior that has not actually hap- g’li‘tsjnish Mehra and Edward C. Prescott, “The Equity Premium: A Puzzle,” Journal of Monetary Economics 15 (1985), PP. 145—61. Chapter 9 Capital Market Theory: An Overview 241 I TABLE 9A. 1 Overall 1802—1870 1871—1925 1926—1999 1802—1999 t Common Stock 6.8 8.5 13.3 9.7 Treasury bills 5.4 4.1 3.8 4.4 Riskpremium 1.4 4.4 9.5 5.3 pened. For example, if people have been very risk—averse and historical borrowing rates have been low, it suggests that persons should have been willing to borrow in periods of economic uncertainty and downturn to avoid the possibility of a reduced stande of living. However, we do not observe increased borrowing during recessions. The equity risk premium puzzle of Mehra and Prescott has been generally Viewed as an unexplained paradox. However, recently, Jeremy Seigel has shown that the historical risk premium may be substantially lower than previously realized (see Table 9A.1). He shows that, while the risk premium averaged 9.5 percent from 1926 to 1999, it averaged only 1.4 percent from 1802 to 1870, and 4.4 percent from 1871 to 1925.10 It is puzzling that the trend has been rising over the last 200 years. It has been especially high since 1926. However, the key point is that historically the risk premium has been lower than in more recent times and we should be somewhat cautious about assumptions we make concern— ing the current risk premium. ‘oleremy J. Seigel, Stocks for the Long Run 2nd ed. (New York City: McGraw—Hill, 1998). ...
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This note was uploaded on 02/27/2012 for the course ARE 171A taught by Professor Whitney during the Spring '08 term at UC Davis.

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are171a-appendix9a - Appendix 9A THE HISTORICAL MARKET RISK...

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