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mandatory defined contribution pensions
the risk-free asset) that investors demand as compensation for absorbing risk. All things being equal, the optimal holdings of risky assets are positively correlated with the risk premium and negatively correlated with the risk penalty. Box 4B.2 summarizes the literature on the risk premium puzzle of U.S. equities, or why that premium appears to have been so high.
Box 4B.2 Equity Risk Premium in the United States The issue of what explains equity risk premium and the puzzle of why it seems to have been so high in the United States has been the subject of a large debate in the economic literature. Mehra and Prescott (1985) suggest that the very high estimated equity premium in the United States of 7.43 percent could be explained only if individuals had implausibly high coefficients of relative risk aversion. Kurz and Beltratti (1996) explain the size of the equity premium using a rational belief equilibrium model where price uncertainty is endogenously propagated, and this uncertainty is the predominant source of volatility in asset returns. Risk-averse investors need to be compensated for this volatility, and using the same parameters as in Mehra and Prescott (1985), Kurz and Beltratti (1996) are able to generate the historically observed equity premium in the United States. Constantinides, Donaldson, and Mehra (2002) and Kogan, Makarov, and Uppal (2007) explain the size of the equity premium in terms of borrowing constraints. Constrained, young individuals cannot invest as they would like in the stock market, and this constraint reduces demand and raises the return on equities above the risk-free rate sufficiently to generate the observed equity premium. Rietz (1988) argues that the size of the equity premium can be explained by low-probability disasters—that is, the possibility that the economy and hence the stock market could be subjected to an extreme negative shock, even if this possibility has a very low probability. Barro (2005) also supports this view and argues that a 1 percent annual probability of a 50 percent fall in gross domestic product (GDP) and the physical capital stock would be sufficient to produce the observed premium as well as the low long-run real return on risk-free government bonds. However, Julliard and Ghosh (2008) argue that the rare-event hypothesis is incompatible with the consumption capital asset pricing model and, therefore, cannot by itself explain historical levels of equity premium, and Jorion and Goetzmann (1999) and Ross, Brown, and Goetzmann (1995) explain the size of the equity premium in terms of survivorship bias, with the observed equity premium being upward biased because of the long-term survival of the markets from which they are measured. Faugère and Van Erlach (2006) argue that the U.S. long-run equity premium is (continued)