Stochastic Implied Rates of Return, Portfolio Optimization, and the Equity Premium Puzzle

44 Pages Posted: 9 Feb 2010 Last revised: 4 Mar 2013

See all articles by Wolfgang Breuer

Wolfgang Breuer

RWTH Aachen University

Marc Gürtler

University of Braunschweig - Institute of Technology, Department of Finance

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

Breuer, Wolfgang and Gürtler, Marc, Stochastic Implied Rates of Return, Portfolio Optimization, and the Equity Premium Puzzle (March 01, 2013). Available at SSRN: https://ssrn.com/abstract=1550259 or http://dx.doi.org/10.2139/ssrn.1550259

Wolfgang Breuer

RWTH Aachen University ( email )

Templergraben 55
D-52056 Aachen, 52056
Germany

Marc Gürtler (Contact Author)

University of Braunschweig - Institute of Technology, Department of Finance ( email )

Abt-Jerusalem-Str. 7
Braunschweig, 38106
Germany

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