Empirical Study of the Equity Premium Puzzle in China’s Stock Market

Abstract

The focus of this thesis is on the equity premium puzzle in China’s stock market. The equity premium puzzle arises from the inability of standard economic models to rationalize the equity premium calculated from historical data in financial market. In the puzzle, the actual premium is much larger than the premium estimated by the standard capital asset pricing model. A unified conclusion on the presence of equity premium puzzle in China’s stock market hasn’t formed yet. Two methods are utilized in the thesis to conduct the empirical study. One is the estimation method of the equity premium and coefficient of relative risk aversion (CRRA) derived from the standard consumption asset pricing model (CCAPM), and the other one is the Hansen-Jagannathan bound test. Empirical estimation of CRRA using the historical data is much higher than the theoretical reasonable range of CRRA between 0 and 10 given by the standard model. The result of the second method shows that the actual variance of stochastic discount factor is always lower than the theoretical minimum variance of stochastic discount factor given the reasonable range of CRRA. Both of the methods indicate the presence of equity premium puzzle in China’s stock market. Further implications of equity premium puzzle to Chinese investors and policy makers are presented.