0 Equity premium

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Pablo Fernández IESE Business School

Equity Premium: Historical, Expected, Required and Implied

Equity Premium: Historical, Expected, Required and Implied
Pablo Fernández* PricewaterhouseCoopers Professor of Corporate Finance IESE Business School Camino del Cerro del Aguila 3. 28023 Madrid, Spain Telephone 34-91-357 08 09. e-mail: fernandezpa@iese.edu

ABSTRACT The equity premiumdesignates four different concepts: Historical Equity Premium (HEP); Expected Equity Premium (EEP); Required Equity Premium (REP); and Implied Equity Premium (IEP). We highlight the confusing message in the literature regarding the equity premium and its evolution. The confusion arises from not distinguishing among the four concepts and from not recognizing that although the HEP is equal for allinvestors, the REP, the EEP and the IEP differ for different investors. A unique IEP requires assuming homogeneous expectations for the expected growth (g), but we show that there are several pairs (IEP, g) that satisfy current prices. We claim that different investors have different REPs and that it is impossible to determine the REP for the market as a whole, because it does not exist. We alsoinvestigate the relationship between (IEP – g) and the risk free rate. There is a kind of schizophrenic approach to valuation: while all authors admit different expectations of equity cash flows, most authors look for a unique discount rate. It seems as if the expectations of equity cash flows are formed in a democratic regime, while the discount rate is determined in a dictatorship.

JEL Classification:G12, G31, M21 Keywords: equity premium; equity premium puzzle; required market risk premium; historical market risk premium; expected market risk premium; risk premium; market risk premium; market premium.

February 16, 2007

*

I would like to thank, without implicating, Michael Brennan, Jose Manuel Campa, George Constantinides, Javier Estrada, Christophe Faugere, Roger Ibbotson, JuanIgnacio Peña, Julio Pindado, Jay Ritter, Jake Thomas and Tuomo Vuolteenaho for feedback and very helpful comments, and to my research assistant, Jose Maria Carabias, for his wonderful assistance.

1
Electronic copy of this paper is available at: http://ssrn.com/abstract=933070

Pablo Fernández IESE Business School 1.

Equity Premium: Historical, Expected, Required and Implied

IntroductionThe equity premium (also called market risk premium, equity risk premium, market premium

and risk premium) is one of the most important, but elusive parameters in finance. Some confusion arises from the fact that the term equity premium is used to designate four different concepts: 1. Historical Equity Premium (HEP): historical differential return of the stock market over treasuries. 2. ExpectedEquity Premium (EEP): expected differential return of the stock market over treasuries. 3. Required Equity Premium (REP): incremental return of the market portfolio over the risk-free rate required by an investor in order to hold the market portfolio1. It is needed for calculating the required return to equity (cost of equity). The CAPM assumes that REP and EEP are unique and that REP = EEP. 4.Implied Equity Premium (IEP): the required equity premium that arises from a pricing model and from assuming that the market price is correct. The four concepts are different2. The HEP is easy to calculate and is equal for all investors3, but the REP, the EEP and the IEP are different for each investor and are not observable magnitudes. We also claim that there is not an IEP for the market as awhole: different investors have different IEPs and use different REPs. A unique IEP requires assuming homogeneous expectations for the expected growth (g), but there are several pairs (IEP, g) that satisfy current prices. An anecdote from Merton Miller (2000, page 3) about the expected market return in the Nobel context: “I still remember the teasing we financial economists, Harry Markowitz,...
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