Discussion: Cash Flow Risk, Discounting Risk, and the Equity Premium Puzzle
Abstract The two-stage calibration approach has long been the workhorse in evaluating the ability of models to match the observed equity premium. The approach calls for calibrating the model’s parameters using data that are not linked to the equity premium and then assessing the ability of the model to match the observed premium. In the following discussion, I demonstrate that calibrating a model to fit the dividend yield series, volatility of prices, or any price to fundamental ratio is likely to produce a large equity premium in a purely mechanical way. Put differently, the practice of calibrating the model to fit dividend yield ...
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