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Average Debt and Equity Returns: Puzzling?

Staff Report 313 | Published January 1, 2003

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Average Debt and Equity Returns: Puzzling?

Abstract

Mehra and Prescott (1985) found the difference between average equity and debt returns puzzling because it was too large to be a premium for bearing nondiversifiable aggregate risk. Here, we re-examine this puzzle, taking into account some factors ignored by Mehra and Prescott—taxes, regulatory constraints, and diversification costs—and focusing on long-term rather than short-term savings instruments. Accounting for these factors, we find the difference between average equity and debt returns during peacetime in the last century is less than 1 percent, with the average real equity return somewhat under 5 percent, and the average real debt return almost 4 percent. As theory predicts, the real return on debt has been close to the 4 percent average after-tax real return on capital. Similarly, as theory predicts, the real return on equity is equal to the after-tax real return on capital plus a modest premium for bearing nondiversifiable aggregate risk.

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Published In: AER, Papers and Proceedings (Vol. 93, No. 2, May 2003, pp. 392-397) https://doi.org/10.1257/000282803321947407

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