Explaining Equity Excess Return by Means of an Agent-Based Financial Market

Abstract

The observed values of equity premium, i.e., the excess return required by investors to hold equities instead of risk-free securities, are usually far larger than values foreseen by consumption capital asset pricing models with realistic aversion to risk. In order to tackle the problem form a different point of view, we present a model of an artificial economy, where different heterogeneous agents are interacting in the financial market. Households, firms, and a commercial bank make endogenous financial decisions which involve portfolio investments for households, capital structure and dividends policy for firms, and lending and borrowing rates for the commercial bank. In particular, households are characterized by behavioral rules derived from prospect theory. Labor income for households and earnings for firms are exogenous determined, according to independent stochastic processes. From simulation experiments it emerges that the model offers new interesting insights on the issue, confirming some hypothesis about the influence of households psychological features on the equity premium dynamics. In particular, the model shows that the length of time over which agents aggregate and evaluate returns, called evaluation period, has a significant role in explaining equity excess returns.