Document Type : Research Paper
Authors
1 PhD student in Monetary Economics, Faculty of Management and Economics, Tarbiat Modares University, Tehran, Iran
2 Associate Professor of Economics, Faculty of Management and Economics, Tarbiat Modares University, Tehran, Iran.
3 Assistant Professor of Economics, Faculty of Management and Economics, Tarbiat Modares University, Tehran, Iran.
Abstract
The equity premium is obtained from the difference between the return on the risky stock asset and the return on the risk-free asset; the failure of financial theory to explain high equity premium is known as the equity premium puzzle. This puzzle was introduced for the first time by Mehra and Prescott in the framework of the C-CAPM model and states that stock returns are so high that it cannot be explained by the fluctuation of real consumption growth. Therefore, the examination of the puzzle is important because it provides the basis for the correction of models that lead to failure when faced with financial data. The purpose of the present study is to investigate the equity premium puzzle in Iran. Focusing on the relationship between the real and financial sectors, this study has specified a DSGE model in accordance with the conditions of Iran's economy. The specified model can investigate the equity premium puzzle in Iran by applying technology shocks, government spending, oil revenue, stock price index shock and money supply and the effect of these shocks on asset returns and consumption. The results show that the productivity shock, oil income shock and stock price shock in the high-risk aversion parameter while smoothing the consumption and creating a high equity premium can explain the equity premium puzzle in Iran.
Introduction
The neoclassical growth model is among the most successful models that have been influential in representing business cycles and macroeconomic issues, but it faces challenges when it comes to financial data. One of the best examples of this challenge is the equity premium puzzle presented by Mehra and Prescott (1985). Using the C-CAPM model, they showed that the empirical equity premium is larger than the risk tolerance in the standard neoclassical models of financial economics; therefore, the equity premium puzzle provided a basis for modifying the standard neoclassical models. So far, various studies have been carried out to modify the model, which provided solutions to solve the Equity premium puzzle. Some studies solved the Equity premium puzzle by introducing economic recession as a state variable (such as the study of Campbell & Cochrane (1999)), Others evaluated the Equity premium puzzle by including consumption habits (such as Constantinides (1990)); Epstein and Zin (1991) also looked for the Equity premium puzzle by separating the relative risk aversion coefficient and the time discount rate. In Iran, research has been done by Mohammadzadeh et al. (2015) and Erfani et al. (2015). By making changes in the C-CAPM model, they evaluated the Equity premium puzzle in Iran. Among the weaknesses of these studies, we can mention the neglect of the connection between the real and financial sectors, as well as the lack of attention to the role of fluctuations in macroeconomic variables in investors' decisions. In this regard, the present study has tried to correct these weaknesses by designing a dynamic stochastic general equilibrium (DSGE) model for the Iranian economy. To be more precise, the purpose of this model is to examine the equity premium puzzle in a more realistic way, because it examines the fluctuations of asset returns and consumption in response to the shocks introduced in the model. The main idea of this model is taken from the study of Kaszab and Marsal (2015).
Methods and Material
The data used in this study are quarterly data (from the first quarter of 1993 to the fourth quarter of 2021) adjusted gross domestic product without oil (minus net exports), oil income, consumer price index, private sector consumption, private investment, monetary base, government spending, stock price index, and the bank deposit rate. The data were collected from the Central Bank of Iran and the Tehran Stock Exchange Organization. The specified DSGE model is simulated using MATLAB software and the Diner program.
Results and Discussion
As mentioned, this study specified the DSGE model with the approach of modifying preferences and focusing on the relationship between the real and financial sectors. The specified model includes 4 sections: household, corporations, financial, and monetary policymakers. The equations obtained from the first-order optimization conditions were linearized by the Uhlig method. The constant weighted ratios were calculated according to the data of Iran's economy and some parameters were calibrated using previous studies, and finally, 2 criteria were used to evaluate the simulated model in MATLAB:
The closeness of the mean and standard deviation of the theoretical variables resulting from calibration to the mean and standard deviation of the real-world variables.
The adaptation of the response of the variables to the shocks applied to the model with the theoretical topics. In table (3), the first criterion has been evaluated:
Table 1. Comparison of mean and standard deviation of simulated variables and real data
The standard deviation
Average
Title
simulated value
real data
simulated value
real data
0.0274
0.0895
0.00000
0.0000
inflation
0.0547
0.0938
0.00000
0.0000
Private investment
0.0251
0.0319
0.00000
0.0000
Private consumption
0.0785
0.2072
0.00000
0.0000
Stock price index
0.0050
0.0763
0.00000
0.0000
Bank deposit rate
Source: Research calculations.
According to the above table, the mean and standard deviation of the simulated variables of the model and the real sample are relatively similar, which reflects the relative ability of the model to predict the fluctuations of the variables.
Evaluation of the second criterion (analysis of immediate response): In the present study, in order to investigate Iran's equity premium puzzle in the form of the DSGE model, taking into account the fact that changes in consumption depend on the preferences of individuals, which is reflected in the intertemporal elasticity of substitution of consumption; the instantaneous response functions of the simulated variables have been investigated in 3 different values of the risk aversion parameter. The values of this parameter are reported in Table 4:
Table 2. Relative risk aversion coefficient values
The first model,
the second model
the third model
Risk aversion parameter
1.65
5.00
12.00
the coefficient value is less than the acceptable range
the coefficient value is within the acceptable range
The coefficient value is greater than the acceptable range
Technology shock:
Table 3. Response functions of simulated variables to technology shock
Source: Research calculations
According to Table (5), in the higher risk aversion parameter (12), a negative correlation between inflation and consumption and a positive correlation between consumption and real stock price index can produce higher positive equity premium and confirm the equity premium puzzle in Iran in short-run, medium-run, and long-run.
Money supply shock:
Table 4. Response functions of the simulated variables to the money supply shock
Source: Research calculations
Money supply shock in higher risk aversion parameter (12), in the short run (up to 4 periods) can explain the equity premium puzzle in Iran.
Government expenditure shock:
Table 5. Response functions of the simulated variables to the government expenditure shock
Source: Research calculations
The shock of government spending in all values of the risk aversion parameter, by creating a positive covariance between consumption and inflation, produces a negative premium for 9 periods and produces a small positive premium from the 9th period until reaching a stable point; therefore, government expenditure shock cannot explain the equity premium puzzle.
Oil income shock:
Table 6. Response functions of the simulated variables to the oil income shock
Source: Research calculations
According to Table (8), in the higher value of the risk aversion coefficient, more premium is produced, which can explain the equity premium puzzle.
Stock price shock:
Table 7. Response functions of simulated variables to stock price shock
Source: Research calculations
This shock can show the equity premium puzzle in the short-run, medium-run, and long-run by producing a positive premium in the value of the high-risk aversion coefficient.
Conclusion
The aim of the present study is to investigate the equity premium puzzle in Iran. Focusing on the relationship between the real and financial sectors, this study specified a DSGE model in accordance with the conditions of Iran's economy; the specified model, assuming that households have sufficient information about the values of risk aversion parameters and consumption habits, was able to solve the Equity premium puzzle in Iran by applying technology shocks, government spending, oil income, stock price index, money supply and the effect of these shocks on asset returns and consumption. The results showed that in the value of the risk aversion parameter higher than the acceptable range, consumption has fewer fluctuations (the reason is the existence of consumption habits). Therefore, since households do not like sudden changes in consumption, then with changes in labor supply, saving or purchasing assets without risk.
The analysis also reveals that when oil income, stock price, and technology shocks impact the risk aversion parameter beyond an acceptable range, a high equity premium emerges in the short, medium, and long term. This elevated equity premium helps explain the equity premium puzzle. Based on these findings, two policy recommendations are suggested for policymakers:
Focus on Structural Parameters: Policymakers should consider structural parameters such as consumption habits and risk aversion, as households are aware of these values. Neglecting these factors may adversely affect policy objectives by misaligning with household expectations.
Leverage the Equity Premium as an Investment Incentive: A high equity premium can encourage investment in riskier assets over risk-free assets under uncertain conditions. While a high premium may help mitigate investor uncertainty and risk aversion, it is essential for policymakers to implement economic programs that minimize fluctuations in macroeconomic indicators and control societal uncertainty.
These considerations underscore the importance of stability in economic policy to support both investment confidence and broader economic goals.
Keywords
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