Equity risk premium in the Finnish stock markets

Abstract

This thesis examines the realized equity premium and the equity risk premium puzzle in Finland during the years from 1913 to 2015. In the U.S. data, it has been noted that the attempt to connect the stock market and consumption data in the context of the consumption-based asset pricing model (CCAPM) leads to an implausibly high risk aversion parameter. The CCAPM restricts also the behavior of the risk-free rate, leading to what is termed the risk-free rate puzzle. We first present the properties of the consumption and stock market returns data, estimate the parameter values implied by the CCAPM for the Finnish data, use a dividend growth model to estimate the unconditional expected equity risk premium and finally examine the short-term predictability of dividend growth and the equity premium.

We find that the joint equity premium and the risk-free rate puzzle does exist also in the Finnish data, though linking the realized average excess return to consumption data does not require a very high value for the risk aversion parameter. Because of the historically high inflation, the real risk-free rate has been very low, and correspondingly, the realized equity premium has been high in Finland. However, the high volatility of consumption growth does much to mitigate the puzzle. Also, the dividend growth estimate of the unconditional expected equity risk premium is not much less than the realized average excess return. We find evidence of short-term predictability in both dividend growth and the realized equity premium.