Explain how the equity risk premium is linked to how well equities hedge consumption
The idea
Investors value an asset not only for its average payoff but for when it pays. An asset that pays off well when consumption is low and each extra unit of wealth is most valuable is a hedge, so investors accept a lower expected return for it, possibly below the risk-free rate. Equities behave the opposite way: profits and prices tend to fall in recessions, exactly when investors most need money, so they are poor consumption hedges and must offer a sizeable equity risk premium above that on default-free bonds. The premium also tends to rise in bad times, when risk aversion is high. The trap is judging the premium from an asset's volatility rather than the timing of its payoffs.
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