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Application of Prospect Theory in Finance: Equity Risk Premium

Equity risk premium -- one of the most famous puzzles in finance.

U.S. equities have outperformed bonds by around 7% per year in the 20th century.

Most models predict only a maximum of 1 – 2% equity risk premium over bonds.

Why should stocks require such a large compensation for their risk?

1. Define EQUITY RISK PREMIUM.

2. Pages 27 - 28 and 69 of the following handout -- 1.3.3.1 Application: Implied Equity Risk Premium and TAA. Using the author's method for deriving the implied equity risk premium on pages 27 - 28 and page 69, construct the implied equity risk premium for the time period 2009 - 2019. You can use S&P 500 Index as the stock market, google and use its dividend yield. Equity Risk Premium Assignment Reading.PDFPreview the document ( first file )

3. Implied Equity Risk Premium = S&P 500 Annual Dividend Yield + Annual GDP Growth Rate - 10-year Bond Yield

4. Using your numbers, comparing them to the market return for the same time period, and discuss whether you agree with the author's statement: "When a stock or market has done well, investors charge less for accepting the risk.

5. Read the following paper and summarize it: https://www.nber.org/papers/w4369.pdf