The Region

Premium puzzle - In Brief

Published December 1, 2009  | December 2009 issue

  • Economists have been unable to explain why stock returns are far higher than bond returns; theory suggests just a 1 percent premium.
  • In recent research, Fatih Guvenen argues that the actual 7 percent premium is generated because stockholders require high returns for assuming risk from non-stockholders. The latter tend to be lower-income people dependent on labor income. They insure themselves with risk-free bonds sold by higher-income people who own stocks. The equity premium is necessary to motivate stockholders to assume aggregate risk and endure business cycle volatility.
  • Guvenen’s model, while not perfect, has intuitive appeal and a strong match to data.

Mystery Solved? - Full Article