The Equity Premium Puzzle

The equity premium puzzle, as early as proposed for the first time in 1985 by Mehra and Prescott, has attracted numerous attentions since its first being raised. Researchers tried to explain this puzzle from different perspectives, and the later researchers make many modifications on the classical theory and put forward different explanations because the classical theory can' t explain the puzzle reasonably. Though these theories explain the puzzle in some sense, hardly anyone was satisfying as a whole.This article focuses on the level of the equity risk premium (ERP) and dopes out its scope. In the course of researching, I do my best to use the method of system theory, induction and deduction, empirical analysis and forecast analysis and so on.Firstly, the paper has totally introduced the developing process of the equity premium puzzle, including the statement of the equity premium puzzle, the domestic and foreign correlation research results and their flaw. Using the year' s data from 1991 to 2006 of Shanghai Stock market composite index in China, the dissertation introduces the standard consumption-based cross time balanced model to analyze the puzzle of the equity premium. It shows that the high equity puzzle exists in China' s stock market. It reached as high as 18. 61% (It was not only higher than theoretical value 1. 65% by far, but also went far beyond the American 6% level). It uses Hansen-Jagannathan bounds and coefficients of relative risk aversion and finds the Chinese investor' s relative risk evasion coefficient is many times than the maximum level considered plausible by Mehra and Prescott in 1985, which is 10. It also proves that the equity puzzle exists in China' s stock market. We study the reason to the equity puzzle which has formed in our country and give persuasive analysis.Secondly, utilizing each week data from 1999.10.22 to 2007. 12.15 of Shanghai Stock market composite index in China, the study has constructed separately based on the Markov Process and the BP Neural Network analysis model to forecast the level of the equity risk premium in China Stock market and their change tendency. This has provided a new tool for investor to make decision of investment.Finally, we conclude this paper briefly.