The fundamental equity premium and ambiguity aversion in an international context

Abstract

Stocks are riskier than bonds. This causes a risk premium for stocks. That the size of this premium, however, seems to be larger than risk aversion alone can explain the so-called "equity premium puzzle". One possible explanation is the inclusion of a degree of ambiguity in stock returns to account for an additional ambiguity premium, whose size depends on the degree of ambiguity aversion among investors. It is, however, difficult to test this empirically. In this paper, we compute the first firm-level estimation of equity premium based on the internal rate of return (IRR) approach for a total of N = 28,256 companies in 54 countries worldwide. Using a survey of international data on ambiguity aversion, we find a strong and robust relation between equity premia and ambiguity aversion.