Does the Market Understand Time Variation in the Equity Premium?

Abstract

We test whether the market has intertemporally consistent expectations about the log equity premium. We use option prices to estimate the expected future equity premium (the forward rate) and compare this to the equity premium estimated in the future (future spot rate). Forward rates are strong predictors of future spot rates, suggesting that the market qualitatively understands variation in the equity premium. The market does, however, make predictable and quantitatively significant forecast errors. To match the data, we propose a model in which an increase in the equity premium causes investors to overestimate the future equity premium.

Keywords: asset pricing, expected stock returns, rational expectations, diagnostic expectations, time-varying discount rates

JEL Classification: G10, G12, G40