Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2013 Edition
Aswath Damodaran (NY University) | March 23, 2013
Equity risk premiums are a central component of every risk and return model in finance and are a key input in 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. 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.
A Fresh Look at the Equity Risk Premium
Anthony Bova, et al. (Investment Symposium, Society of Actuaries) | March 14-15, 2013
• On both theoretical and empirical grounds, the geometric mean is preferred to the arithmetic mean for pension plans. Using the arithmetic mean would have led to forecast returns much higher than those actually realized.
• Stationarity and standard error indicate there is significant uncertainty in using historical ERP to forecast returns.
• Implicit or market based ERP methods have the advantage of reflecting current market conditions. When pension plan assets are valued at market as of the date of valuation, it would be consistent to have an ERP calculated as of the same day. Implied ERPs fall in bull markets and rise in bear markets, while historical ERPs do the opposite.
The Equity Risk Premium in 2013
John Graham and Campbell Harvey (Duke University) | January 28, 2013
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 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 has decreased to a level of 3.83% which is only slightly higher than the long-term average. However, the total market return forecast is at a historical low of 5.46%. The survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. Consistent with the last four quarters of surveys, CFOs see more downside risks than upside risks. In addition, we find that dispersion of beliefs is above the long-term average as well as individual uncertainty. 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 divergence between VIX and the risk premium.
Corridor Volatility Risk and Expected Returns
George Dotsis and Nikolaos Vlastakis (University of Essex) | February 8, 2013
n this paper we examine the pricing of volatility risk using SPX corridor implied volatility. We decompose model-free total implied volatility into various components using different segments of the cross section of out-of-the money put and call option prices. We find that only model-free volatility computed from the cross section of out-of-the-money call option prices carries a significant negative risk premium in the cross section of stock returns and also contains all relevant information for forecasting future volatility risk. Overall, our empirical results provide strong evidence that SPX out-of-the money put option prices do not contain useful information for capturing systematic volatility risk in equity returns.
Risk, Uncertainty, and Expected Returns
Turan Bali (Georgetown University) and Hao Zhou (Tsinghua University) | January 2013
A conditional 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, annualized 6 to 8 percent premium relative to portfolios that are minimally correlated with VRP.