Publication Date
Financial Markets Group Discussion Papers DP 974
The equity premium has conventionally been defined as the return on stocks minus the return on bills. We decompose this conventional definition into two components: the pure equity premium, defined as stocks minus duration-matched inflation-indexed bonds, and the real term premium, defined as duration-matched inflation-indexed bonds minus bills. Empirically, we find that the pure equity premium has no “puzzling” features, as it not only has a relatively low Sharpe ratio but also a high correlation with measured consumption growth. However, challenges remain: The real term premium has a high sample mean and volatility, and realizations of the pure equity premium and real term premium are very negatively correlated.
