The equity premium in China

ABSTRACT

The equity premium is a key indicator in capital investment decisions. However, few studies estimate the equity premium for the Chinese stock market. To shed more light on the subject, we use dividend and consumption growth models to estimate the expected equity premium in China from 2005 to 2017. Our evidence shows that the geometric mean of the expected yearly equity premium from the consumption growth model, 9.69 percent, is similar to that of the realized yearly equity premium from stock returns, 8.11 percent. The corresponding values are 0.74–0.68 percent for monthly data, and 2.49–2.28 percent for quarterly data. In contrast, the estimate of the expected equity premium from the dividend growth model is far higher than the realized equity premium. However, both the dividend and consumption growth models fail to explain the high fluctuations of the realized equity premium.

KEYWORDS:

• Equity premium
• stock return
• dividend growth model
• consumption growth model

JEL CLASSIFICATION:

• G10
• G12

Acknowledgments

We would like to thank Zhenwei Lv and Xiangtong Meng for their helpful discussions and comments.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ See, for example Mehra and Prescott (1985), Rietz (1988), Mehra and Prescott (1988), Weil (1989), Chang (1990), Kocherlakota (1996), Campbell (2000), Lettau and Ludvigson (2001), Zhang (2005), Mehra and Prescott (2008a), Lettau, Ludvigson, and Wachter (2008), Dimson, Marsh, and Staunton (2008), David (2008), Jermann (2010), Donaldson, Kamstra, and Kramer (2010), Mehra (2012), Kang and Kim (2012), Wang and Huang (2015), and Avdis and Wachter (2017).

² See, for example Harvey (1995) and Bekaert and Harvey (1997).

³ The Chinese stock market, the biggest emerging stock market in the world, was started in 1992. Considering the frequent adjustments to trading rules in the first decade, our sample excludes the early, unstable data. In addition, the CSI 300 (China Securities Index 300) was formed in 2005; it consists of the 300 largest and most liquid A-share stocks, and aims to reflect the overall performance of the Chinese A-share market.

⁴ See, for example, Campbell and Shiller (1988) and Zhang, Zhou, and Xiong (2019).

⁵ Fama and French (2002) argue that the earnings–price ratio is stationary and set the growth rate of earnings as another estimate of the expected rate of capital gain.

⁶ This is in line with Dimson, Marsh, and Staunton (2003) who argue that the geometric mean is a more reasonable estimate of average equity premium than the arithmetic mean when a time series shows high fluctuation. In fact, the estimate of realized equity premium is systematically high in the period with sharp rises and falls. This is because the rate of rise is mostly higher than the rate of fall. For example, the price of a market portfolio rises by 100 percent in the first year, and then falls by 50 percent in the next year. The estimate of market return, 25 percent per year, is far more than the real market return, which is zero.

⁷ The yearly dividend yield $D_t/P_{t-1}$ in the Chinese stock market, 2.96 percent, is smaller than the corresponding value in developed markets, such as the US market, about 3.70 percent.

Additional information

Funding

This work was supported by the National Natural Science Foundation of China [71532009,71790590,71790594], and Scientific Research Start-up Program for Talents of Guizhou University of Finance and Economics [2019YJ037].