The Equity Premium Puzzle: A Review

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The Equity Premium Puzzle reviews the literature on this phenomenon from the original papers by Mehra and Prescott to the present. The author shows that the equity premium - the return earned by a broad market index in excess of that earned by a relatively risk-free security - is not a premium for bearing non-diversifiable risk. It documents the historical equity premium in the United States and in selected countries with significant capital markets, examines the question, ‘Is the equity premium a premium for bearing non-diversifiable risk?’, addresses risk and preference based explanations of the equity premium, and reviews the nascent literature that takes as given the findings in Mehra and Prescott (1985) and tries to account for the equity premium by factors other than aggregate risk.

The Equity Premium Puzzle offers a birds-eye view of the literature explained by one of the authors of the pioneering work in this area. This is must reading for all students and scholars of finance and macroeconomics.