Research Review | 4 May 2018 | Equity Risk Premium

The Equity Risk Premium in 2018
John R. Graham and Campbell R. Harvey (Duke University)
March 27, 2018
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 December 2017. The risk premium is the expected 10-year S&P 500 return relative to a 10-year U.S. Treasury bond yield. The average risk premium is 4.42% and is somewhat higher than the average observed over the past 18 years. We also provide results on the risk premium disagreement among respondents as well as asymmetry or skewness of risk premium estimates. We also link our risk premium results to survey-based measures of the weighted average cost of capital and investment hurdle rates. The hurdle rates are significantly higher than the cost of capital implied by the market risk premium estimates.

Equity Risk Premiums: Determinants, Estimation and Implications – 2018 Edition
Aswath Damodaran (New York University)
March 14, 2018
The equity risk premium is the price of risk in equity markets and is a key input in estimating costs of equity and capital in both corporate finance and valuation. Given its 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 the equity risk premium, historical returns are used, with the difference in annual returns on stocks versus bonds, over a long 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. In the next section, we 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 Macroeconomic Announcement Premium
Jessica A. Wachter and Yicheng Zhu (University of Pennsylvania)
March 14, 2018
Empirical studies demonstrate striking patterns in stock market returns in relation to scheduled macroeconomic announcements. First, a large proportion of the total equity premium is realized on days with macroeconomic announcements, despite the small number of such days. Second, the relation between market betas and expected returns is far stronger on announcement days as compared with non-announcement days. Third, risk as measured by volatilities and betas is equal on both types of days. We present a model with rare events that jointly explains these phenomena. In our model, which is solved in closed form, agents learn about a latent disaster probability from scheduled announcements. We quantitatively account for the empirical findings, along with other facts about the market portfolio.

The Equity Risk Premium and the Low Frequency of the Term Spread
Gonçalo Faria (Catholic U. of Portugal) and Fabio Verona (Bank of Finland)
April 3, 2018
We extract cycles in the term spread (TMS) and study their role for predicting the equity risk premium (ERP) using linear models. The low frequency component of the TMS is a strong and robust out-of-sample ERP predictor. It obtains out-of-sample R-squares (versus the historical mean benchmark) of 1.98% and 22.1% for monthly and annual data, respectively. It forecasts well also during expansions and outperforms several variables that have been proposed as good ERP predictors. Its predictability power comes exclusively from the discount rate channel. Contrarily, the high and business-cycle frequency components of the TMS are poor out-of-sample ERP predictors.

Term Structure(s) of the Equity Risk Premium
Leandro Gomes (Gávea Investimentos) and Ruy Ribeiro (PUC-Rio)
March 19, 2018
By simultaneously using dividend and variance swap data, we show how the term structure of the equity risk premium varies over time and how its shape is affected by liquidity risk premia. The term structure is always positively sloped, while funding liquidity premia and betas explain the high unconditional returns for all dividend claims. Alphas for short-dated dividend claims become negative, whereas alphas for long-dated claims seem to be positive. The term structure slope varies positively with the market risk premium, but it is never negative relative to the first contract – due to the nearly zero risk premium in the first maturity – and rarely hump-shaped in some empirical models. We demonstrate how the maturity term structure – the risk premium for dividend strips with different maturities – is connected to both the horizon term structure – linked to the variance swap term structure – and various funding liquidity measures. The risk premium is on average increasing with investment horizon, while the 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 risk premium depends primarily on the short-horizon risk premium, implying that short-horizon investors are the marginal ones. All our results hold in the US, the UK, Europe and Japan. All these facts are consistent with, for instance, a long-run risk model with jump risks.

Macroeconomic Tail Risks and Asset Prices
David Schreindorfer (Arizona State University)
February 15, 2018
I document that dividend growth for the aggregate U.S. stock market is more correlated with consumption growth in bad economic times than in good times. In a consumption-based asset pricing model with a generalized disappointment averse investor and i.i.d. consumption growth, this feature results in a realistic equity premium for low levels of risk aversion. Consistent with empirical estimates, the model predicts that the equity premium predominantly compensates investors for bearing stock market crash risk. It matches the average prices and returns of equity index options with different strike prices and resolves three prominent puzzles about stock market risk premia that are implied by options. Lastly, the model admits analytical solutions for all asset prices.

Hedging Risk Factors
Bernard Herskovic (University of California, Los Angeles), et al.
March 24, 2018
Standard risk factors can be hedged with minimal reduction in average return. This is true for “macro” factors such as industrial production, unemployment, and credit spreads, as well as for “reduced form” asset pricing factors such as value, momentum, or profitability. Low beta versions of the factors perform close to as well as high beta versions, hence a long short portfolio can hedge factor exposure with little reduction in expected return. For the reduced form factors this mismatch between factor exposure and expected return generates large alphas. For the macroeconomic factors, hedging the factors also hedges business cycle risk by significantly lowering exposure to consumption, GDP, and NBER recessions. We study implications both for optimal portfolio formation and for understanding the economic mechanisms for generating equity risk premiums.

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