Average debt and equity returns: puzzling?

Ellen R. McGrattan and Edward C. Prescott

No 313, Staff Report from Federal Reserve Bank of Minneapolis

Abstract: Mehra and Prescott (1985) found the difference between average equity and debt returns puzzling because it was too large to be a premium for bearing nondiversifiable aggregate risk. Here, we re-examine this puzzle, taking into account some factors ignored by Mehra and Prescott-taxes, regulatory constraints, and diversification costs-and focusing on long-term rather than short-term savings instruments. Accounting for these factors, we find the difference between average equity and debt returns during peacetime in the last century is less than 1 percent, with the average real equity return somewhat under 5 percent, and the average real debt return almost 4 percent. As theory predicts, the real return on debt has been close to the 4 percent average after-tax real return on capital. Similarly, as theory predicts, the real return on equity is equal to the after-tax real return on capital plus a modest premium for bearing nondiversifiable aggregate risk.

New Economics Papers: this item is included in nep-dge and nep-fin
Date: Written
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Published in American Economic Review, Papers and Proceedings (Vol. 93, No. 2, May 2003, pp. 392-397)

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Related works:
Working Paper: Average Debt and Equity Returns: Puzzling? (2003)
Journal Article: Average Debt and Equity Returns: Puzzling? (2003)
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