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Equity Premium

Governments are largely insulated from market forces. Companies are not. Investments in stocks therefore carry substantial risk in comparison with holdings of government bonds, notes or bills. The marketplace presumably rewards risk with extra return. How much of a return premium should investors in equities expect? These blog entries examine the equity risk premium as a return benchmark for equity investors.

The Equity Risk Premium Through 2008

How has stock market behavior during the 2000s affected estimates of the U.S. equity risk premium? In the February 2009 version of their paper entitled “The Equity Premium Revisited”, Bradford Cornell, Robert Arnott and Max Moroz update estimates of the equity risk premium to incorporate the generally weak U.S. stock market performance through 2008. They consider three models to estimate the premium relative to an annualized real commercial paper yield: (1) dividend yield plus capital gains; (2) dividend yield plus dividend growth rate; and, (3) dividend yield plus earnings growth rate. Using historical data for dividends, earnings, stock market returns (for the S&P 500 and antecedents) and six-month commercial paper yields spanning 1872-2008 (with focus on 1951-2008), they conclude that: Keep Reading

Trading Frictions Over the Long Run

Careful assessment of the exploitability of premiums or anomalies derived from long-run series such as stock indexes requires consideration of contemporaneous trading frictions. How have frictions changed over time? In the May 2002 version of his paper entitled “A Century of Stock Market Liquidity and Trading Costs”, Charles Jones assembles annual long-run series of three components of aggregate liquidity: (1) proportional bid-ask spreads for large-capitalization NYSE stocks (1900-2000); (2) proportional commissions for NYSE stocks (1925-2000); and, (3) turnover for NYSE stocks (1900-2000). He applies these series to explore the relationship between stock market returns and aggregate liquidity over time. Using a range of sources to calculate bid-ask spreads for the Dow Jones/DJIA stocks and commission, volume and return data for a broader sample of NYSE stocks, he finds that: Keep Reading

Fear of Disasters?

Is fear of rare stock market plunges a major factor in the pricing of equities? In the March 2010 version of their paper entitled “Tails, Fears and Risk Premia”, Tim Bollerslev and Viktor Todorov apply highly empirical methods to examine the distribution of large rare events and the effects of these events on the equity risk premium and the volatility risk premium. Specifically, they define and measure an Investors Fears index driven by: (1) slow variation in investment opportunities (for example, due to economic and demographic influences); and, (2) large rare events (for example, due to economic and political crises). Using high-frequency (five-minute) prices for S&P 500 Index futures prices during 1990-2008 and prices for near-to-expiration out-of-the-money S&P 500 Index options during 1996-2008, they conclude that: Keep Reading

The 2008 Equity Risk Premium from Academia

What is the current academic estimate of the annual premium over the risk-free rate demanded by equity investors. How has that estimate changed over the past year and since 2000? In his February 2009 paper entitled “Market Risk Premium Used in 2008: A Survey of More Than a 1,000 Professors”, Pablo Fernández summarizes the results of an early 2009 email survey soliciting the risk premium “that we, professors, use to calculate the required return to equity” in 2008 and in previous years. Based on 1,161 responses to the survey from finance and economic professors around the world, he finds that: Keep Reading

The Prospective “Academic” Equity Risk Premium

What is the latest reading on the future equity risk premium from the academic community? In his January 2008 paper entitled “The Consensus Estimate For The Equity Premium by Academic Financial Economists in December 2007”, Ivo Welch answers this question. Based on 369 “core” responses to a survey of finance professors conducted during late December 2007, he finds that: Keep Reading

The Belief Component of Risk Premiums

Is risk premium variation principally a consequence of changes in objective business conditions, or is some human dynamic important? In their November 2007 paper entitled “Diverse Beliefs and Time Variability of Risk Premia”, Mordecai Kurz and Maurizio Motolese examine the effect of diverse but individually rational market beliefs on risk premiums. They define belief as a variable independent of all observed fundamentals, with its own dynamic that reflects changes in the distribution of investor risk perceptions. Using monthly interest rate forecasts compiled by Blue Chip Financial Forecasts since 1983 to measure market beliefs and associated actual interest rate data, they conclude that: Keep Reading

Calibrating Ancient History

Is there a way to deal with structural breaks more precisely than just expressing vague skepticism about the usefulness of old data? In the April 2007 draft of their paper entitled “How Useful Are Historical Data for Forecasting the Long-run Equity Return Distribution?”, John Maheu and Thomas McCurdy describe and test a methodology for identifying and calibrating structural breaks in long-term excess equity returns. Using monthly U.S. equity return and risk-free rate data for the period February 1885 through December 2003, they conclude that: Keep Reading

The Professor’s Forecast for the Indefinite Future…

…looks something like this: Keep Reading

Honing in on the Prospective U.S. Equity Risk Premium

What is the latest from academia regarding the prospective equity risk premium? In their November 2006 paper entitled “Estimating the Ex Ante Equity Premium”, Glen Donaldson, Mark Kamstra and Lisa Kramer apply new simulation techniques across ten distinct models to calculate what they claim “is by far the most precise equity premium estimate that has been reported in the literature to date.” Using U.S. dividend growth rates, interest rates, Sharpe ratios, price-dividend ratios, return volatilities and the historical equity premium for 1952-2004 to calibrate their simulations, they conclude that: Keep Reading

An Equity Risk Premium Opus

What excess return have you gotten, do you expect, should you require, does the market imply for taking the risk of owning stocks? In his September 2006 paper entitled “Equity Premium: Historical, Expected, Required and Implied”, Pablo Fernandez addresses all these questions in a comprehensive overview/history and analysis of the equity risk premium in the U.S. and other countries. He begins with definitions of four perspectives on the equity premium, the first equal for all investors and the other three varying among investors: Keep Reading

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