A Model for the Ex-Ante U.K. Stock Market Risk Premium

Keywords

Ex-Ante Risk Premium, Dividend Yield, Earnings Yield, Kalman Filter

Abstract

We propose a model for the aggregate stock market together with its dividend yield and earnings yield so that the ex-ante risk premium could be extracted in an unobserved component modelling framework. We posit the model as a linked stochastic differential equation system and the linking variable is the ex-ante risk premium. By hypothesising a realistic dynamic structure for the ex-ante risk premium, we demonstrate how such a system could be estimated as a filtering problem. As a practical demonstration of the methodology we apply the model to the U.K. stock market data.

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