Discounting The Equity Premium Puzzle

Recent tests of stochastic dominance of several orders proposed by Linton, Maasoumi and Whang (2003) are applied to reexamine the equity premium puzzle. An advantage of this nonparametric framework is that it provides a means to assess whether the existence of a premium is due to particular cardinal choices of either the utility function or the underlying returns distribution, or both. The approach is applied to a number of data sets including the original Mehra-Prescott data and more recent data that includes daily yields on Treaury bonds and daily returns on the S&P500 and the NASDAQ indexes. The empirical results show little evidence of stochastic dominance amongst the assets investigated. This suggests that there is no puzzle and that the observed equity premium indeed represents the price for bearing higher risk, taking into account higher order moments such as skewness and kurtosis.