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Abstract

An implicit assumption of the conditional CAPM is that the ex ante equity risk premium is positive in all states of the world. Studies on US portfolios by Boudoukh, Richardson and Smith (1993) and on world portfolios by Ostdiek (1998) find violations of this assumption. This paper seeks to test the sign of the equity risk premium in the Australian market using two parallel tests. First, the series is examined for the presence of two regimes using a test developed in Bayesian inference. Truncated normal priors are applied to the means in this test to specifically detect means of opposite sign. Once a negative regime is identified in the risk premium, we try to identify it ex ante using the test developed by Boudoukh, Richardson and Smith (1993). This test allows the moments implied by the model to be conditioned on observable information. We were able to reject the null of a single regime in favour of the two-regime model using the regime-switching test. In addition the inequality tests on contemporaneous data rejected the restriction of a positive risk premium.

Keywords

EQUITY RISK PREMIUM INEQUALITY TESTING REGIME SWITCHING BAYESIAN ANALYSIS

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Is the Ex Ante Risk Premium Always Positive? Further Evidence

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