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The equity premium puzzle: High required equity premium, undervaluation and self fulfilling prophecy

Pablo Fernandez, Javier Aguirreamalloa and Heinrich Liechtenstein
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Javier Aguirreamalloa: IESE Business School, Postal: Research Division, Av Pearson 21, 08034 Barcelona, SPAIN
Heinrich Liechtenstein: IESE Business School, Postal: Research Division, Av Pearson 21, 08034 Barcelona, SPAIN

No D/821, IESE Research Papers from IESE Business School

Abstract: We argue that the equity premium puzzle may be explained by the fact that most market participants (equity investors, investment banks, analysts, companies¿) do not use standard theory (such as a standard representative consumer asset pricing model) for determining their Required Equity Premium, but rather, they use historical data and advices from textbooks and finance professors. Consequently, ex-ante equity premia have been high, market prices have been consistently undervalued, and the ex-post risk premia has been also high. Professors use in class and in their textbooks high equity premia (average around 6%, range from 3 to 10%), and investors use higher equity premia for valuing companies (average around 6%). The overall result is that equity prices have been, on average, undervalued in the last decades and, consequently, the measured ex-post equity premium is also high. As most investors use historical data and textbook prescriptions to estimate the required and the expected equity premium, the undervaluation and the high ex-post risk premium are self fulfilling prophecies.

Keywords: equity premium puzzle; required equity premium; historical equity premium (search for similar items in EconPapers)
JEL-codes: G12 G31 M21 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2009-09-07
New Economics Papers: this item is included in nep-fmk and nep-upt
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Citations: View citations in EconPapers (1)

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