Excess volatility in equity risk premium model

In stock market, investors are looking for profit, they buy stocks and sell others, but before buying or selling stocks they must think carefully because each decision may be the path to losses. Investors are concerned by expecting future movements in stock prices to sell stocks whose process will decrease and buy stocks whose prices will increase. Their expectations must be built in basis of stocks under-valuations and over-valuations. But, in 1981 Shiller introduced new concept in stock market which is excess volatility. Excess volatility is the excess dispersion of stock prices relatively to their fundamental values. This new concept implies that stocks are too volatile and they incur several sequences of under-valuations and over-valuations in short period, hence investors’ expectations will be less accurate and more uncertain. This involves investors to be aware of excess volatility risk. In this study, we reported that several researchers proved the imminent existence of stock prices excess volatility in stock market. The best way to get aware of excess volatility risk is to understand the factors behind excess volatility. Indeed, four factors are the sources of excess volatility in stock prices, Knightian uncertainty, learning, investors’ behavior irrationality and overconfidence. Excess volatility is a common risk factor, this property make it one of common risk factors that must be integrated in equity risk premium model. But this step requires eventually a previous one; which is to find a proxy to stock prices excess volatility. As market stock prices are mean reverting towards their fundamental values, this specification was the first basis of excess volatility proxy we proposed in this study