The market price of risk and the equity premium: A legacy of the Great Depression?

Timothy Cogley, Thomas J. Sargent

    Research output: Contribution to journalArticlepeer-review

    Abstract

    By positing learning and a pessimistic initial prior, we build a model that disconnects a representative consumer's subjective attitudes toward risk from the high price of risk that a rational-expectations econometrician would deduce from financial market data. We follow Friedman and Schwartz [1963. A Monetary History of the United States, 1857-1960. Princeton University Press, Princeton, NJ] in hypothesizing that the Great Depression heightened fears of economic instability. We use a robustness calculation to elicit a pessimistic prior for a representative consumer and let him update beliefs via Bayes' law. Learning eventually erases pessimism, but while it persists, pessimism contributes a volatile multiplicative component to the stochastic discount factor that a rational-expectation econometrician would detect. With sufficient initial pessimism, the model generates substantial values for the market price of risk and equity premium and predicts high Sharpe ratios and forecastable excess stock returns.

    Original languageEnglish (US)
    Pages (from-to)454-476
    Number of pages23
    JournalJournal of Monetary Economics
    Volume55
    Issue number3
    DOIs
    StatePublished - Apr 2008

    Keywords

    • Asset pricing
    • Learning
    • Market price of risk
    • Robustness

    ASJC Scopus subject areas

    • Finance
    • Economics and Econometrics

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