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The Equity Premium For Durham E-Theses The equity risk premium puzzle revisited: The case of the UK stock market. Vivian, Andrew J. How to cite: Vivian, Andrew J. (2007) The equity risk premium puzzle revisited: The case of the UK stock market., Durham theses, Durham University. Available at Durham E-Theses Online: http://etheses.dur.ac.uk/2445/ Use policy The full-text may be used and/or reproduced, and given to third parties in any format or medium, without prior permission or charge, for personal research or study, educational, or not-for-prot purposes provided that: • a full bibliographic reference is made to the original source • a link is made to the metadata record in Durham E-Theses • the full-text is not changed in any way The full-text must not be sold in any format or medium without the formal permission of the copyright holders. Please consult the full Durham E-Theses policy for further details. Academic Support Oce, Durham University, University Oce, Old Elvet, Durham DH1 3HP e-mail: [email protected] Tel: +44 0191 334 6107 http://etheses.dur.ac.uk THESIS TITLE THE EQUITY RISK PREMIUM PUZZLE REVISITED: THE CASE OF THE UK STOCK MARKET. BY ANDREW J. VIVIAN The copyright of this thesis rests with the author or the university to which it was submitted. No quotation from it, or information derived from it may be published without the prior written consent of the author or university, and any information derived from it should be acknowledged. SUBMITTED FOR THE QUALIFICATION OF Ph.D. IN FINANCE UNIVERSITY OF DURHAM DURHAM BUSINESS SCHOOL SEPTEMBER 2007 1 2 JUN 2008 Thesis Abstract The Equity Risk Premium Puzzle Revisited: The Case of the UK Stock Market Andrew J. Vivian This thesis stimulated and inspired by failings in the current literature investigates a series of issues relating to the UK Equity Risk Premium Puzzle. The UK market is focussed upon given prior research is heavily concentrated on the US market. The prior literature also focuses upon the aggregate equity premium. This thesis makes another important extension to prior work by analysing the equity premium for portfolios formed on cross-sectional characteristics such as size or industry. Specifically, it addresses the following three main issues. Firstly, is the historical equity premium an appropriate proxy for the expected equity premium? Secondly, does the use of the ex-post equity premium overstate the magnitude of the ex-ante equity premium puzzle? Thirdly, do low frequency equity returns follow different regimes over time? The main results indicate that the alignment of ex-post equity returns with fundamental measures of equity returns depends upon both the time period considered and the measure of fundamental used. Empirical evidence also supports the view that the expected equity premium follows different regimes and thus does vary over time. This low-frequency time variation in expected returns appears to, in general, be systematic, affecting portfolios within the market at a similar time. Our results contribute to the academic literature and also have important implications for practitioners by offering insight into the nature of the Equity Premium Puzzle and the appropriateness of using ex-post returns as a proxy for ex-ante returns. The material contained in this thesis has not been previously submitted for a degree in this or any other university. The copyright of this thesis rests with the author. No quotation from it should be published in any format, including electronic or internet forms, without the author's prior written consent. All information derived from this thesis must be acknowledged appropriate! y. Work largely based on this thesis entitled, "The UK Equity Premium: 1901-2004" by Andrew Vivian has been published in the Journal of Business Finance and Accounting Volume 34 Pages 1496-1527. ACKNOWLEDGMENTS: I am extremely grateful for the guidance, help and assistance given by my supervisors ' Professor Tony Antoniou, Dr. Andreas Reschreiter and Professor Robert Sallis during my doctoral studies. They have helped nurture a deep interest in Financial research and offered me constructive suggestions and advice. I would also like to express my thanks to colleagues and fellow research students of the Department of Economics and Finance in Durham who have encouraged an supported me during my studies. CHAPTER 1: THESIS INTRODUCTION 1 CHAPTER 2: LITERATURE REVIEW 12 2.1 EQUITY PREMIUM PUZZLE LITERATURE REVIEW 12 2.2.1 DEFINITION OF THE EQUITY PREMIUM PUZZLE 15 2.2.2 MODIFICATIONS TO THE UTILITY FUNCTION 17 2.2.3 RATIONAL ECONOMIC MODIFICATIONS TO THE UTILITY FUNCTION 18 2.2.4 BEHAVIOURAL FINANCE APPROACH 23 2.2.5 INDIVIDUALS REALLY ARE EXTREMELY RISK A VERSE 27 2.2.6 MARKET IMPERFECTIONS 30 2.2.7 INCOMPLETE MARKETS 33 2.2.8 HETEROGENEOUS AGENT MODELS 36 2.2.9 CONSUMPTION-BASED ASSET PRICING IS A FUNDAMENTALLY FLAWED IDEA? 38 2.2.1 0 CONCLUSION 39 I 2.3 LITERATURE REVIEW ON CALCULATING EQUITY PREMIUM 41 2.3.1 EMPIRICAL MODELING OF ASSET RETURNS 41 2.3.2 ARE HISTORICAL, REALISED RETURNS AN ACCEPTABLE PROXY FOR INVESTORS' EXPECTED RETURNS? 43 2.3.3 CONCLUSIONS AND RECOMMENDATIONS 53 2.4 LITERATURE REVIEW ON THE SIZE PREMIUM 58 2.4.1 SIZE EFFECT VARIES OVER TIME 59 2.4.2 CAPM 61 2.4.3 APT 61 2.4.4 SIZE PROXIES FOR AN UNOBSERVABLE RISK-FACTOR 64 2.4.5 FIRM SIZE AND THE JANUARY SEASONAL 65 2.4.6 OPERATIONAL EFFICIENCY EXPLANATIONS 66 2.4.7 DATA MINING 68 2.4.8 OTHER ALTERNATIVE EXPLANATIONS 69 2.4.9 SUMMARY OF SIZE PREMIUM LITERATURE 70 2.5 LITERATURE REVIEW CONCLUSION 71 II CHAPTER. 3: THE EQUITY PREMIUM: 101 YEARS OF EMPIRICAL EVIDENCE FROM THE UK 75 3.1 INTRODUCTION 75 3.2 MODEL AND DATA DESCRIPTION 80 3.2.1 MODEL 80 3.2.2 EQUIVALENCE OF FAMA-FRENCH AND GORDON DIVIDEND GROWTH MODELS 84 3.2.3 DATA DESCRIPTION 87 3.2.4 DESCRIPTIVE STATISTICS 89 3.2.5 STATIONARITY TESTS 92 3.3 ANNUAL EQUITY RETURNS 98 3.3.1 EMPIRICAL EVIDENCE FROM THE UK MARKET 98 3.3.2 UK EMPIRICAL EVIDENCE FROM 10 YEAR SUB-SAMPLES 103 3.4 EXPLAINING UK EQUITY RETURNS 106 3.4.1 WHAT HAS CAUSED THE REALISED RETURN TO EXCEED THE RETURN IMPLIED BY FUNDAMENTALS BY SO MUCH? 106 3.4.2 ARE POST 2000 EXPECTED DIVIDEND GROWTH RATES UNUSUALLY HIGH? 106 ill 3.4.2.1 IN-SAMPLE PREDICTABILITY OF DIVIDEND GROWTH USING ALL POSSIBLE CANDIDATE VARIABLES 108 3.4.2.2 IN-SAMPLE PREDICTABILITY OF DIVIDEND GROWTH USING PARSIMONIOUS REGRESSIONS 112 3.4.2.3 IN-SAMPLE PREDICTABILITY: CONCLUSION 116 3.4.3 IS DIVIDEND GROWTH (1951-2002) UNEXPECTEDLY HIGH? 118 3.4.3.1 OUT OF SAMPLE FORECASTING OF DIVIDEND GROWTH 119 3.4.3.2 OUT-OF-SAMPLE FORECASTING OF DIVIDEND GROWTH: METHODOLOGY 121 3.4.3.3. OUT-OF-SAMPLE FORECASTING OF DIVIDEND GROWTH: TIME-VARIATION IN B 123 3.4.3.4 OUT-OF-SAMPLE FORECASTING: PERFORMANCE EVALUATION METHODOLOGY 127 3.4.3.5. OUT-OF-SAMPLE FORECASTING 1 YEAR DIVIDEND GROWTH: RESULTS 129 3.4.3.6. OUT-OF-SAMPLE FORECASTING 2 YEAR DIVIDEND GROWTH: RESULTS 131 3.4.3.7 OUT-OF-SAMPLE FORECASTING CONCLUSION 135 IV 3.4.4 DO EXPECTED STOCK RETURNS FALL DURING THE 1951-2002 PERIOD? 137 3.5 CONCLUSION 144 CHAPTER 4: THE EQUITY PREMIUM - UK INDUSTRY EVIDENCE 147 4.1 INTRODUCTION 147 4.2 DATA DESCRIPTION AND METHODOLOGY 152 4.2.1 DATA DESCRIPTION 152 4.2.2 RETURN AND EQUITY PREMIA ESTIMATING EQUATIONS 156 4.2.3 PANEL REGRESSION METHOD 159 4.2.4 STRUCTURAL BREAK TESTS 160 4.2.5 UNIT ROOT TESTS 163 4.3 INDUSTRY EQUITY PREMIA ESTIMATES 165 4.4 EXPLAINING UK EQUITY RETURNS 176 4.4.1 ARE POST 2000 EXPECTED DIVIDEND AND EARNINGS GROWTH RATES HIGH? 176 4.4.2 WAS THERE ANY CHANGE IN UK EXPECTED STOCK RETURNS OVER 1966-2002? 189 v 4.5 CONCLUSION 203 CHAPTER 5: THE EXPECTED SIZE PREMIUM: 1966a2002 207 5.1 INTRODUCTION 207 5.2 MODEL AND DATA DESCRIPTION 210 5.2.1 MODEL 211 5.2.2 DATA DESCRIPTION 214 5.2.3 UNIT ROOT TESTS 219 5.2.3.1 EMPIRICAL RESULTS OF UNIT ROOT TESTS: 1966-2002 219 5.3 ANNUAL SIZE PORTFOLIO RETURNS 222 5.3.1.1 SIZE PORTFOLIOS: ONE WAY SORT 222 5.3.1.2 IMPACT OF 1974 STOCK MARKET CRASH 223 5.3.1.3 PRE-DISCOVERY PERIOD: 1966-1984 (INCLUDING IMPACT OF MARKET CRASH) 228 5.3.1.4 POST-DISCOVERY PERIOD: 1985-2002 230 5.3.1.5 PERFORMANCE OF 1989-1998: COMPARISON WITH DIMSON AND MARSH (1999) 233 5.3.2.1 TWO WAY SORTED SIZE-VALUE PORTFOLIOS 234 VI 5.3.2.2 FULL SAMPLE PERIOD 1966-2002 235 5.3.2.3 IMPACT OF 1974 STOCK MARKET CRASH 240 5.3.2.4 PRE-DISCOVERY PERIOD: 1966-1984 (INCLUDING IMPACT OF MARKET CRASH) 242 5.3.2.5 POST-DISCOVERY PERIOD: 1985-2002 243 5.3.2.6 PERFORMANCE OF 1989-1998: COMPARISON WITH DIMSON AND MARSH (1999) 247 5.4 EXPLAINING UK EQUITY RETURNS 248 5.4.1 WHAT CAUSES THE DISCREPANCIES WE FOUND IN UK EQUITY PREMIA? 248 5.4.1.1 ARE POST 2000 EXPECTED DIVIDEND AND EARNINGS GROWTH RATES UNUSUALLY HIGH? 249 5.4.1.2 IN-SAMPLE PREDICTABILITY USING ALL POSSffiLE CANDIDATE VARIABLES 250 5.4.1.3 IN-SAMPLE PREDICTABILITY USING GENERAL-TO- SPECIFIC APPROACH 256 5.4.1.4 FORECASTING FUTURE FUNDAMENTAL GROWTH 261 5.4.1.5 CONCLUSION 268 5.4.2 DO EXPECTED STOCK RETURNS FALL DURING THE 1966-2002 PERIOD? 269 5.4.2.1 SIZE PORTFOLIOS 271 VII 5.4.2.2 SUMMARY 283 5.5 CONCLUSION 287 CHAPTER 6: SUMMARY OF FINDINGS AND CONCLUDING REMARKS 295 BIBLIOGRAPHY 308 vm LIST OF 1'ABLES TABLE 3.1: DESCRIPTIVE STATISTICS AND CORRELATIONS 91 TABLE 3.2: UNIT ROOT TESTS (1901-2002) 94 TABLE 3.3: UK AND US ESTIMATES OF EQUITY PREMIA 99 TABLE 3.4: UK EQUITY PREMIA BY DECADE 103 TABLE 3.5: IN-SAMPLE PREDICTABILITY OF REAL DIVIDEND GROWTH 109 TABLE 3.6: ONE YEAR DIVIDEND GROWTH FORECASTING PERFORMANCE 131 TABLE 3.7: ONE YEAR DIVIDEND GROWTH- TESTS OF EQUAL FORECAST ACCURACY 132 TABLE 3.8: TWO YEAR DIVIDEND GROWTH FORECASTING PERFORMANCE
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