Pure Equity Premium

The equity premium is conventionally the return on stocks minus the risk-free rate (for short-term government bills). What should be the risk-free asset for equities, arguably expected to grow in real terms and never to mature? In the November 2025 draft of their paper entitled “Purifying the Equity Premium”, Christopher Polk and Tuomo Vuolteenaho argue that the risk-free asset as applied to equities should be a long-term inflation-indexed bond and therefore decompose the equity premium into two components:

1. Pure equity premium – stock market return minus the yield on duration-matched inflation-indexed bonds, such as Treasury Inflation-Protected Securities (TIPS). See the chart below.
2. Real term premium – yield on duration-matched inflation-indexed bonds minus the yield on short-term bills.

The conventional equity premium is the sum of these two components. Using value-weighted stock market and U.S. Treasury bonds/bills data for the U.S. since February 1997 and comparable data for the UK since August 1987, along with relevant economic data, all through June 2025, they find that: (more…)