APPLICATION OF BEHAVIORAL FINANCE IN MODELING BULGARIAN EQUITY RISK PREMIUM

Abstract

The paper seeks a plausible explanation of the magnitude of equity risk premium, by modeling leading behavioral concepts in the conditions of Bulgarian capital market. Firstly, the fair equity risk premium is derived by basic neoclassical consumption-based model. Subsequently, the conducted comparison between fair and empirical risk premium indicates that the demanded compensation by investors for owning Bulgarian stocks cannot be rationally explained, i.e. there is an equity risk premium puzzle on BSE. On this basis, we have applied a behavioral model based on two well-known characteristics of human behavior in conditions of risk and uncertainty – loss aversion and narrow framing. Set at reasonable levels of risk and loss aversion, the model has managed to generate risk-free rate and market returns close to empirical levels.