Question

One of the main anomalies relating to the aggregate stock market is the equity premium puzzle.

1.1 Describe the equity premium. Why is it deemed to be a puzzle?

1.2. Discuss the difficulties associated with the calculation of the equity premium.

1.3. Many researchers consider that the equity premium is too high. Discuss this viewpoint.

1.4. Discuss the rational explanations for the equity premium puzzle.

1.5. What is the behavioural explanation for the equity premium puzzle?

Answer 1

Answer(1.1): Equity Premium- This is the excess return over risk free return in the stock market. When investor is willing to take extra risk for getting excess return from the market, this is called equity premium.

It is deemed to be a puzzle because equity premium is different in all the countries. It is difficult to know the extent of premium and also difficult to calculate the equity premium. How much risk should be taken to get the high return, sometimes even after high risk, there is no or very less return due to efficient market hypothesis.

Answer(1.2) Difficulties in calculating Equity premium- For calculating equity premium, firstly expected return on stock is calculated using CAPM or other model then difference between expected return on stock and risk free return is the equity premium. It is hard to find the accurate return on stock, estimation could be wrong sometimes. stock market is very uncertain and volatile, future prices cannot be predict correctly on the basis of past prices.

Answer(1.5) Investors who seek fixed income with moderate risk go for fixed income securities and bonds but investors who are risk averse person and they are willing to take risk for getting high returns, they get premium returns. Equity is considered a risky product and investors who do proper research funadmenattly and technically, get the above average return.