The Stock Risk Premium Demystified (Updated)

There was some degree of confusion on the risk premium during Thursday’s class. I have posted a handout (to the right) that hopefully clarifies what I was trying to get at, by simplifying some of the things we were discussing.

I have strayed from the text book slightly by illustrating some concepts like the expected earnings on stocks. I don’t think that the text differentiates between actual earnings and expected earnings. It is these expected earnings that actually make the the stock risk premium more interesting for us as macroeconomists, since they display the inherent expectations in the stock market, and how these, along with the risk premium can affect the stock price.

Also, in order to avoid some confusion regarding the bond market, I have – for the sake of the analysis – assumed that interest rates don’t change. Towards the end of the handout, I mention what happens to the stock price if interest rates do change. This is important, so please make sure that this point is also clear with you.

I will discuss this in class on Tuesday, so please read the handout before coming in. I think that for those of you who had a lot of questions about this, it should put at least some (if not all) of your doubts to rest. Meanwhile, if this raises even more questions which, in some of you at least, it might – feel free to drop me a line or leave a comment here.

Update: I just remembered that I had written briefly about this for an earlier class, and uploaded an old article from the NYT. Read the handout (posted on the right), and read the original blog-post. Some more blog-posts on the risk premium: [1],[2].

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