Date of Award

1-1-2004

Degree Type

Thesis

Degree Name

Master of Business

School

School of Business

Faculty

Faculty of Business and Public Management

First Advisor

Professor David Allen

Abstract

The gap between the return on stocks and the return on the risk free assets represented by bonds is named the 'Equity Premium' or 'Equity Risk Premium'. In the history of asset pricing models, one of the most serious problems for the equity premium is that the average equity premium is too large to be explained by standard general equilibrium asset pricing models. Researcher's have tried to use variables such as dividend yield's to explain the gap between stocks and bonds with mixed results. After retrieving around a one percent equity premium with the most standard consumption base asset pricing models or Lucas styled asset pricing model, Mehra and Prescott (1985) first recognised this problem and announced it as a 'Puzzle'. In their analysis they used Lucas's (1978) standard asset pricing model where a representative investor has additive and separable utility functions in the perfect market. Compared to other forms or utility functions, at a certain period, these conventional preferences derived from utility of consumption in previous periods. Also this utility maintains a constance risk aversion parameter, y, over the reasonable consumption boundaries. In this study two approaches are adopted. The first involves the commonly applied dividend yield approach to forecasting the equity premium. The results obtained from using the current and lagged divided yield to try to capture the size and movement in the market risk premium are shown in chapter three. The results are not particularly promising. The remainder of the dissertation is devoted to a more sophisticated model: the consumption capital asset pricing model with habit derived by Campbell and Cochrane (1995) is tested using Australian data. The utility specification separates the temporal choice from state contingent choice and in doing so resolves part of the equity premium puzzle. The model is able to generate an equity premium using consumption data that is collinear with the actual premium, but with a significantly different volatility. The conclusion is that the state and time separable model is only partly able to resolve Mehra and Prescott’s (1985) equity premium puzzle.

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