Where Do Equity Risk Premia Come From?

15 Pages Posted: 7 Jul 2020 Last revised: 10 Nov 2020

See all articles by Kent Osband

Kent Osband

Institute for Studies on the Mediterranean (ISMed)

Date Written: November 9, 2020

Abstract

Standard finance theory posits that equity risk premia compensate for occasional shortfalls in aggregate consumption. However, observed premia are much higher than typical consumption risks warrant. Insurance against rare disaster risks reconciles only some of the differential, unless risk aversion is implausibly high and if equity dividends are mis-identified with aggregate consumption. Equity markets are better modeled as casino games with evolving risks, with pricing dominated by rational gamblers seeking long-term enrichment. While their effective risk aversion is modest, the risks of drawdown appear high enough to justify a risk premium of several hundred basis points.

Keywords: risk premium, equity pricing, expected utility, constant relative risk aversion, intertemporal elasticity of substitution, disaster risks, Kelly criterion, fractional Kelly

JEL Classification: D11, G11, G12

Suggested Citation

Osband, Kent, Where Do Equity Risk Premia Come From? (November 9, 2020). Available at SSRN: https://ssrn.com/abstract=3638731 or http://dx.doi.org/10.2139/ssrn.3638731

Kent Osband (Contact Author)

Institute for Studies on the Mediterranean (ISMed) ( email )

Naples
Italy

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