Why the equity premium is called a puzzle?
The equity premium is regarded as a puzzle because it is very difficult to explain how the returns on equities have been significantly higher on an average, compared to the returns on Treasury bonds, based upon investor risk aversion.
What is the equity risk premium puzzle?
The equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of U.S. equities over that of U.S. Treasury Bills, which has been observed for more than 100 years.
Why is it called risk-free rate?
It is often called the risk-free interest rate. When an investment is risk-free, it means that the actual return that an investor obtains equals the expected return. When investors purchase assets, they have returns that they expect to make over a year, six-months, or other time horizons.
How prospect theory explains the equity premium puzzle?
Recent research on prospect theory has shown that it is applicable in finance, insurance, and other areas. Prospect theory can explain such financial phenomena as the equity risk premium puzzle, the lower long-term average returns of IPOs, and the lack of diversification in many household portfolios.
What is the volatility puzzle?
Finance textbooks say that more volatile assets should have higher returns. The volatility puzzle is that that doesn’t always hold true. A five-year window was used to find the volatility of each of the stocks. For each month the volatility was broken into quintiles.
How does government benefit from equity premium puzzle?
When the price of the borrowed capital falls below the return rate in the capital markets, the government can issue bonds and invest the raised capital on the capital market. These leveraged investments yield a net profit to the government, which is reinforced when taking the equity premium puzzle into account.
What is the excess volatility puzzle?
Proponents of behavioral finance have identified several “puzzles” in the market that are inconsistent with rational finance theory. One such puzzle is the “excess volatility puzzle”. Changes in equity prices are too large given changes in the fundamentals that are expected to change equity prices.
What is the risk-free rate example?
The value of a risk-free rate is calculated by subtracting the current inflation rate from the total yield of the treasury bond matching the investment duration. For example, the Treasury Bond yields 2% for 10 years. Then, the investor would need to consider 2% as the risk-free rate of return.
What does risk-free means?
risk-free. adjective. used to describe something that does not involve any risk: This strategy is not entirely risk-free. risk-free assets.
What is excess volatility?
Excess volatility is the name given to that level of volatility over and above that which is predicted by efficient market theorists. In Shiller’s eyes this excess volatility can be attributed to investors’ psychological behaviour.
What is idiosyncratic volatility?
Based on asset-pricing models, idiosyncratic volatility measures the part of the variation in returns that cannot be explained by the particular asset-pricing model used.