Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Equity Risk Premium: A Review of Models

Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Equity Risk Premium: A Review of Models

Article excerpt

1. INTRODUCTION

The equity risk premium--the expected return on stocks in excess of the risk-free rate--is a fundamental quantity in all of asset pricing, both for theoretical and practical reasons. It is a key measure of aggregate risk-aversion and an important determinant of the cost of capital for corporations, the savings decisions of individuals, and budgeting plans for governments. Recently, the equity risk premium (ERP) has also moved to the forefront as a leading indicator of the evolution of the economy, a potential explanation for jobless recoveries, and a gauge of financial stability. (1)

In this article, we estimate the ERP by combining information from twenty prominent models used by practitioners and featured in the academic literature. Our main finding is that the ERP has reached heightened levels. The first principal component of all models--a linear combination that explains as much of the variance of the underlying data as possible--places the one-year-ahead ERP in June 2012 at 12.2 percent, above the 10.5 percent reached during the financial crisis in 2009 and at levels similar to those in the mid- and late 1970s. From June 2012 to the end of our sample in June 2013, the ERP has changed little, despite substantial positive realized returns. It is worth keeping in mind, however, that there is considerable uncertainty around these estimates. In fact, the issue of whether stock returns are predictable is still an active area of research. (2) Nevertheless, we find that the dispersion in estimates across models, while quite large, has been shrinking, potentially signaling increased agreement even when the models differ substantially from one another and use more than one hundred different economic variables.

In addition to estimating the level of the ERP, we investigate the reasons behind its recent behavior. Because the ERP is the difference between expected stock returns and the risk-free rate, a high estimate can be the result of expected stock returns being high or risk-free rates being low. We conclude that the ERP is high because Treasury yields are unusually low. Current and expected future dividend and earnings growth play a smaller role. In fact, expected stock returns are close to their long-run mean. One implication of a bond-yield-driven ERP is that traditional indicators of the ERP like the price-dividend or price-earnings ratios, which do not use data from the term structure of risk-free rates, may not be as good a guide to future excess returns as they have been in the past.

As a second contribution, we present a concise and coherent taxonomy of ERP models. We categorize the twenty models into five groups: predictors that use historical mean returns only, dividend discount models, cross-sectional regressions, time-series regressions, and surveys. We explain the methodological and practical differences among these classes of models, including the diverse assumptions and data sources that they require.

2. THE EQUITY RISK PREMIUM: DEFINITION

Conceptually, the ERP is the compensation that investors require to make them indifferent at the margin between holding the risky market portfolio and a risk-free bond. Because this compensation depends on the future performance of stocks, the ERP incorporates expectations of future stock market returns, which are not directly observable.

At the end of the day, any model of the ERP is a model of investor expectations. One challenge in estimating the ERP is that it is not clear what truly constitutes the market return and the risk-free rate in the real world. In practice, the most common measures of total market return are based on broad stock market indexes, such as the S&P 500 or the Dow Jones Industrial Average, which do not include the whole universe of traded stocks and miss several other components of wealth such as housing, private equity, and nontradable human capital. Even if we restricted ourselves to all traded stocks, we would still have several choices to make, such as whether to use value or equal-weighted indexes, and whether to exclude penny or infrequently traded stocks. …

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