Discussion Paper Details
Please find the details for DP5519 in an easy to copy and paste format below:
Title: The Declining Equity Premium: What Role Does Macroeconomic Risk Play?
Author(s): Martin Lettau, Sydney Ludvigson and Jessica Wachter
Publication Date: March 2006
Keyword(s): equity premium, macroeconomic volatility, regime shifts and stock market boom
Programme Area(s): Financial Economics and International Macroeconomics
Abstract: Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy. Empirically, we find a strong correlation between low frequency movements in macroeconomic volatility and low frequency movements in the stock market. To model this phenomenon, we estimate a two-state regime switching model for the volatility and mean of consumption growth, and find evidence of a shift to substantially lower consumption volatility at the beginning of the 1990s. We then use these estimates from post-war data to calibrate a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth. Plausible parameterizations of the model are found to account for a significant portion of the run-up in asset valuation ratios observed in the late 1990s.
For full details and related downloads, please visit: https://cepr.org/active/publications/discussion_papers/dp.php?dpno=5519
Lettau, M, Ludvigson, S and Wachter, J. 2006. 'The Declining Equity Premium: What Role Does Macroeconomic Risk Play?'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=5519