The Equity Premium Implied by Production
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.
I am grateful for the comments received from seminar participants at the following locations: Wharton, UBC, BI School, Board of Governors, Federal Reserve Bank of Philadelphia, NYU, 2005 SED meeting, University of Chicago, UCLA, Carnegie-Mellon, HEC Lausanne, USC, Columbia University, and the University of Texas at Austin. In particular, I like to thank for comments from Andy Abel, Fernando Alvarez, Harjoat Bhamra, Joao Gomes and Stavros Panageas, and for research assistance from Jianfeng Yu. The most recent version of this paper can be found at http://finance.wharton.upenn.edu/~jermann/research.html
Jermann, Urban. "The Equity Premium Implied by Production." Journal of Financial Economics. Volume 98, Issue 2, November 2010, Pages 279-296 citation courtesy of