Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2012 Edition
Aswath Damodaran (NYU Stern School of Business) | March 2012
Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. We begin this paper by looking at the economic determinants of equity risk premiums, including investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and volatile. We look at two other approaches to estimating equity risk premiums – the survey approach, where investors and managers are asked to assess the risk premium and the implied approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in non-equity markets. We also look at the relationship between the equity risk premium and risk premiums in the bond market (default spreads) and in real estate (cap rates) and how that relationship can be mined to generated expected equity risk premiums. We close the paper by examining why different approaches yield different values for the equity risk premium, and how to choose the “right” number to use in analysis.
The Equity Risk Premium in 2012
John R. Graham (Duke and NBER) and Campbell R. Harvey (Duke and NBER) | March 2012
We analyze the history of the equity risk premium from surveys of U.S. Chief Financial Officers (CFOs) conducted every quarter from June 2000 to March 2012. The risk premium is the expected 10-year S&P 500 return relative to a 10-year U.S. Treasury bond yield. While the risk premium sharply increased during the financial crisis peaking in February 2009, the premium steadily fell until the second quarter 2010. The current surveys show that the premium has increased to near to the levels during the financial crisis. The survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. We find that dispersion of beliefs is above average as well as individual uncertainty. We find little relation between our survey-based risk premium and a measure of the implied cost of capital that relies on individual firms’ forecasted future cash flows. We also present evidence on the determinants of the long-run risk premium. Our analysis suggests the level of the risk premium closely tracks both market volatility (reflected in the VIX index) as well as credit spreads. However, the most recent data show a puzzling divergence between VIX and our measure of the risk premium. Our analysis suggests that market volatility is inexplicably low.
Rethinking the Equity Risk Premium
P. Brett Hammond, Jr., et al. (CFA Institute) | 2011
In 2001, a small group of academics and practitioners met to discuss the equity risk premium (ERP). Ten years later, in 2011, a similar discussion took place, with participants writing up their thoughts for this volume. The result is a rich set of papers that practitioners may find useful in developing their own approach to the subject.
Shares and shibboleths: How much should people get paid for investing in the stockmarket?
The Economist | March 2012
The big question, however, is how large that extra return should be. Here it is important to distinguish between the extra return investors actually achieved for holding equities (what could be called the ex post number) and the return they expected to achieve when they bought them (the ex ante figure). Academics started to focus on this problem in the mid-1980s when a paper by Rajnish Mehra and Edward Prescott indicated that the ex post return of American equity investors had been remarkably high, at around seven percentage points a year. It seems unlikely that investors expected to do so well.
Risk, Uncertainty, and Expected Returns
Turan G. Bali (Georgetown University) and Hao Zhou (Federal Reserve) | March 2012
A consumption-based asset pricing model with risk and uncertainty implies that the time-varying exposures of equity portfolios to the market and uncertainty factors carry positive risk premiums. The empirical results from the size, book-to-market, and industry portfolios as well as individual stocks indicate that the conditional covariances of equity portfolios (individual stocks) with market and uncertainty predict the time-series and cross-sectional variation in stock returns. We find that equity portfolios that are highly correlated with economic uncertainty proxied by the variance risk premium (VRP) carry a significant premium relative to portfolios that are uncorrelated or lowly correlated with VRP. The insignificant alpha estimates indicate that the conditional asset pricing model proposed in the paper also explains the industry, size, and value premiums.
Time-Variation in the International Diversification Benefits
Wan-Jiun Paul Chiou (Shippensburg University) and Kuntara Pukthuanthong (San Diego State University) | March 2012
Does the economic value of internationally diversified portfolios shrink over time in an increasingly integrated global market? How do the dynamics of global economy and financial markets affect the benefits of international diversification? What is a proper measure of diversification benefits? In contrast to previous research, this paper specifically models the investment constraints associated with liquidity and portfolio feasibility. We find that, although the world market is more integrated, the time-varying benefits of global diversification remain positive. The addition of weighting bounds decreases a portion of diversification benefits, but this addition also decreases the uncertainty of gains and asset allocation and induces diversity in the diversified portfolio. Correlation is not associated with the potential diversification benefits but adjusted R-squared from a multifactor model is. Inflation risk, default risk premium, liquidity and size of equity market are associated with the diversification benefits.