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Equity Risk Premiums (ERP): Determinants, Estimation and Implications – A Post‐Crisis Update

Equity Risk Premiums (ERP): Determinants, Estimation and Implications – A Post‐Crisis Update I. INTRODUCTION 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 http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Financial Markets, Institutions & Instruments Wiley

Equity Risk Premiums (ERP): Determinants, Estimation and Implications – A Post‐Crisis Update

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Publisher
Wiley
Copyright
© 2009 New York University Salomon Center and Wiley Periodicals, Inc.
ISSN
0963-8008
eISSN
1468-0416
DOI
10.1111/j.1468-0416.2009.00151.x
Publisher site
See Article on Publisher Site

Abstract

I. INTRODUCTION 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

Journal

Financial Markets, Institutions & InstrumentsWiley

Published: Dec 1, 2009

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