Stochastic Implied Rates of Return, Portfolio Optimization, and the Equity Premium Puzzle
44 Pages Posted: 9 Feb 2010 Last revised: 4 Mar 2013
Date Written: March 01, 2013
Abstract
We show analytically under quite general conditions that time-varying implied rates of return based on analysts’ earnings forecasts are only a downward biased estimator for future expected one-period returns and therefore not suited for computing market risk premia in order to resolve the equity premium puzzle. The extent of this bias is substantial as verified by a bootstrap approach. We present an alternative estimation equation for future expected one-period returns based on current and past implied rates of return that is superior to simple estimators based on historical returns due to a lower variance of estimation results. The superiority of this new approach for portfolio selection purposes is verified numerically for our bootstrap environment and empirically for real capital market data.
Keywords: analysts’ dividend forecasts, equity premium puzzle, implied rate of return, portfolio optimization
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation
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