Risk premium and convexity premium in the stock return

Abstract

We model and estimate equity premium in a general equilibrium setting. It is done by reframing the Merton's model (1974) in the context of general equilibrium models such as Ahn and Thompson (1988) and Bates (1991). Our approach is novel in its attempt to derive equity premium by evaluating the equity returns dynamics in equilibrium and to thereby estimate non-risk convexity premium for equity as well as its risk premium. While risk premium is generally due to systematic risk, convexity premium is due to the option-like feature of equity, and exists under returns discontinuity and risk neutrality. We model equity premium such that the convexity premium pays for the liquidity and information costs of equity. We calibrate our equity premium model and report that the convexity premium counts for about one third of our predicted equity premium. We find relevance for our nonrisk convexity premium in relation to the premium puzzle and anomalies in the stock market. © 2012 Korean Securities Association.