The Equity Premium Implied by Production
NBER Working Paper No. 12487
This paper studies the determinants of the equity premium as implied by producers’ first-order conditions. A closed form expression is presented for the Sharpe ratio at steady-state as a function of investment volatility and adjustment cost curvature. Calibrated to the U.S. postwar economy, the model can generate a sizeable equity premium, with reasonable volatility for market returns and risk free rates. The market’s Sharpe ratio and the market price of risk are very volatile. Contrary to most models, the model generates a negative correlation between conditional means and standard deviations of aggregate excess returns.
Published: Jermann, Urban. "The Equity Premium Implied by Production." Journal of Financial Economics. Volume 98, Issue 2, November 2010, Pages 279-296