The Equity Premium Puzzle post the Financial Crisis

Abstract: The purpose of this paper is to take a closer look at the equity premium puzzle which is one of the most intriguing puzzles in economics and has been challenging researchers for the last 25 years since Mehra and Prescott first introduced the puzzle. It refers to the empirical fact that risky equity has been outperforming default free debt with about 6 percentage points for the U.S. market. The fact that the historical equity premium has been about 6 percentage points means that we have a puzzle on our hands. The puzzle stems from the fact that the perceived risk related to the equity returns is not high enough to explain these high returns. Investors would need to have implausibly high risk-aversion coefficients to demand such high premiums. However, unless the risk aversion coefficient is large, a high equity premium is impossible since the growth rate of consumption just does not vary enough. Another striking aspect of the puzzle is that, although the risk aversion has been high according to the puzzle, the risk free rate of returns has been extremely low over a long period of time. The equity premium puzzle could, therefore, just as easily be called the risk-free rate puzzle. The research in this paper is conducted on Icelandic data for the period 1996-2010 and U.S. data for the period 1889-2010. The authors show that the recent financial crisis has had huge impact on the Icelandic equity market while the bigger U.S. equity market has not been as affected. During the last 10 years, however, the default free debt has been outperforming the more risky equity, which has not been the case the last 100 years. Does this mean that the puzzle has vanished? However, when looking at the puzzle from an historical perspective the excessively high equity premium relative to risk-free short term debt still remains a puzzle.