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FIN501 Asset Pricing

Lecture 06 Equity Premium Puzzle (1)


LECTURE 06: SHARPE RATIO, BONDS, &
THE EQUITY PREMIUM PUZZLE
Markus K. Brunnermeier
FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (2)
Money, Bonds vs. Stocks
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SP500
US 1y Tsy
US 10Y Tsy
FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (3)
Sharpe Ratios and Bounds
Consider a one period security available at date
with payoff
+1
. We have


+1

+1

or


+1


+1
+cov
+1
,
+1


For a given
+1
we let
+1

=
1


+1

Note that
+1

will depend on the choice of


+1
unless there exists a
riskless portfolio

+1
is the return from to +1, typically measurable w.r.t.
+1
. (An
exception is

, which is measurable w.r.t.

, but we stick with


subscript +1.)

FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (4)
Sharpe Ratios and Bounds (ctd.)
Hence

=
1

+1


+1
Expected PV
+ cov
+1
,
+1
Risk Adjustment

Positive correlation with the discount factor adds
value, i.e. decreases required return
FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (5)
in Returns


+1

+1
=


Divide both sides by

and note that

+1

=
+1


+1

+1
= 1
Using
+1

= 1/


+1
, we obtain


+1

+1

+1

= 0
-discounted expected excess return for all assets
is zero.


FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (6)
in Returns
Since


+1

+1

+1

= 0
cov


+1
,
+1

+1


+1


+1

+1


That is, risk premium or expected excess return


+1

+1

=
cov


+1
,
+1


+1

is determined by its covariance with the
stochastic discount factor

FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (7)
Sharpe Ratio
Multiply both sides with portfolio


+1

+1

=
cov


+1
,
+1


+1


+1

+1

=

+1
,
+1

+1

+1


+1


NB: All results also hold for unconditional expectations

Rewritten in terms of Sharpe Ratio = ...


+1

+1

+1
,
+1
=

+1

+1


+1


FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (8)
Hansen-Jagannathan Bound
Since 1,1 we have

+1

+1
sup


+1

+1


+1


Theorem (Hansen-Jagannathan Bound):
The ratio of the standard deviation of a
stochastic discount factor to its mean exceeds
the Sharpe Ratio attained by any portfolio.
FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (9)
Hansen-Jagannathan Bound
Theorem (Hansen-Jagannathan Bound):
The ratio of the standard deviation of a stochastic
discount factor to its mean exceeds the Sharpe
Ratio attained by any portfolio.
Can be used to easy check the viability of a
proposed discount factor
Given a discount factor, this inequality bounds
the available risk-return possibilities
The result also holds conditional on date t info

FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (10)
expected
return
R
f
s
available portfolios
slope s (m) / E[m]
Hansen-Jagannathan Bound
FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (11)
Assuming Expected Utility

0
,
1



0
,
1
=


0
,
1,
U(c
0
,c
1
)

0
=

0

,
1,1

0
, ,

0

,
1,

1
=

0

,
1,1

1,1
, ,

0

,
1,

1,


Stochastic discount factor
=
MRS

=

1



FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (12)
Time-Separable
Digression: if utility is in addition time-separable

0
,
1
=
0
+
1

Then

0
=

0

0
, ,

0

1
=

1,1

1,1
, ,

1,

1,

And

=
1


1,


0
=


1,


0


FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (13)
A simple example
= 2,
1
=
1
2

3 securities with
1
= 1,0 ,
2
= 1,0 ,
3
= 1,1
Let =
1
2
, 1 , =
1
4
=
1
2
1
2

3
4
2
+
1
2
1
3
4
2

Hence,
1
=
1
4
,
2
=
1
2
=
3
=
3
4
and

1
= 4,0 ,
2
= 0,2 ,
3
=
4
3
,
4
3


1
= 2,
2
= 1,
3
=
4
3

FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (14)
Example: Where does SDF come from?
Representative agent with
Endowment: 1 in date 0, (2,1) in date 1
Utility
0
,
1
,
2
=

ln
0
+ln
1,

i.e.
0
,
1,
= ln
0
+ln
1,
(additive) time separable u-
function
=

1
1,2,1

0
1,2,1
=

0

1,1
,

0

1,2
=
1
2
,
1
1
=
1
2
, 1
since endowment=consumption
Low consumption states are high m-states
Risk-neutral probabilities combine true probabilities and
marginal utilities.


FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (15)
Equity Premium Puzzle
Recall

cov ,


Now:

cov
1
,


Recall Hansen-Jaganathan bound




; =
1





FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (16)
Equity Premium Puzzle (ctd.)












Equity Premium Puzzle
high observed Sharpe ratio of stock market indices
low volatility of consumption
) (unrealistically) high level of risk aversion

u u
c
1
c
2
c
1
c
2
FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (17)
Equity Premium or
Low Risk-free Rate Puzzle?
Suppose we allow for sufficiently high risk
aversion s.t.

1



New problem emerges:
Strong force to consumption smooth over time
(low intertemporal elasticity of consumption (IES))
due to concavity of utility function
vNM utility function
smoothing over states = smoothing over time
CRRA gamma = 1/ IES
Model predicts much higher risk-free rate
FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (18)
Equity Premium or
Low Risk-free Rate Puzzle?
Solution:
depart from vNM utility preference representation
Found preference representation that allows split
Risk-aversion
Intertemporal elasticity of substitution

Kreps-Porteus (special case: vNM)
Epstein-Zin (special case: CRRA vNM)
FIN501 Asset Pricing
Lecture 06 Equity Premium Puzzle (19)
Digression: Preference for the timing of
uncertainty resolution
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p
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Early (late) resolution if W(P
1
,) is convex (concave)
Kreps-Porteus
Do you want to know whether you will get cancer at the age of 55 now?

0

1
,
2
=
1
,
1

1
,
2