Equity spread puzzle and credit spread puzzle

Equity Premium Puzzle

The equity premium puzzle refers to the phenomenon that observed returns on stocks over the past century are much higher than returns on government bonds. It is a term coined by Rajnish Mehra and Edward C. Prescott in 1985,[1][2]although in 1982 Robert J. Shiller published the first calculation that showed that either a large risk aversion coefficient or counterfactually large consumption variability was required to explain the means and variances of asset returns.[3]Economists expect arbitrage opportunities would reduce the difference in returns on these two investment opportunities to reflect the risk premium investors demand to invest in relatively more risky stocks.

The intuitive notion that stocks are much riskier than bonds is not a sufficient explanation of the observation that the magnitude of the disparity between the two returns, the equity risk premium (ERP), is so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomics and financial economics.

Simply saying, the implied risk aversion is higher than the risk aversion.

Credit Spread Puzzle

Observed bond spreads are too high compared to spreads implied by expected default losses.

General components for spreads

  • Liquidity premium
  • State tax premium
  • Expected default loss premium
  • Risk premium

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