Dissecting the Equity Premium

We use option prices and realized returns to decompose risk premia into different parts of the return state space. In the data, 8/10 of the average equity premium is attributable to monthly returns below 210%, but returns below 230% matter very little. In contrast, prominent asset pricing models based on habits, long-run risks, rare disasters, undiversifiable idiosyncratic risk, and constrained intermediaries attribute the premium predominantly to returns above 210% or to the extreme left tail. We show that the discrepancy arises from an unrealistically small price of risk for stock market tail events in the models.