Equity Risk Premium: Expectations Great and Small

The Equity Risk Premium (ERP) is an essential building block of the market value of risk. In theory, the collective action of all investors results in an equilibrium expectation for the return on the market portfolio excess of the risk-free return, the equity risk premium. The ability of the valuation actuary to choose a sensible value for the ERP, whether as a required input to CAPM valuation, or any of its descendants, is as important as choosing risk-free rates and risk relatives (betas) to the ERP for the asset at hand. The historical realized ERP for the stock market appears to be at odds with pricing theory parameters for risk aversion. Since 1985, there has been a constant stream of research, each of which reviews theories of estimating market returns, examines historical data periods, or both. Those ERP value estimates vary widely from about minus one percent to about nine percent, based on a geometric or arithmetic averaging, short or long horizons, short or long-run expectations, unconditional or conditional distributions, domestic or international data, data periods, and real or nominal returns. This paper will examine the principal strains of the recent research on the ERP and catalogue the empirical values of the ERP implied by that research. In addition, the paper will supply several time series analyses of the standard Ibbotson Associates 1926-2002 ERP data using short Treasuries for the risk-free rate. Recommendations for ERP values to use in common actuarial valuation problems will be offered.

Keywords: Equity Risk Premium, Risk Premium Puzzle, Market Return Models, CAPM, Dividend Growth Models, Actuarial Valuations.