Luxury Goods and the Equity Premium

What a great article The equity risk premium has puzzled researchers for years. In a nutshell it is the finding that the equity risk premium demanded by investors is too large to be explained by changes in stock returns or changes in consumption unless very high levels of risk aversion were assumed. (See Grossman-Schiller, 1981, Mehra-Prescott 1985). In a forthcoming JF article, Ait-Sahalia, Parker, and Yogo may have taken much of the mystery out of the puzzle. Acknowledging that the puzzle can not be explained by looking at co-movements with overall consumption, the authors, break consumption down into basic and luxury components. Predictably the luxury component of consumption is more volatile AND “covaries significantly more with stock returns than does aggregate consumption.” Then when the equity premium is examined relative to the consumption of the luxury consumption, the size of the premium can be explained by a much lower risk aversion. Additionally, rather than relying on inaccurate government data or biased reported data, the authors look at actual consumption of luxury goods. A VERY cool paper!!!!!!! I was so excited by this one I ran down and interrupted a colleague. Be sure to read it! [ Annotation]

Editor’s Note: Our finance professor friend may have been excited by this paper, but I wonder if you will be as well when you see that it is a dense 60 pages…

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