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Equity Risk Premium Definition
Equity risk premium refers to rate of profit or return that can be earned on financial instruments above the average rate of return. The equity risk premium is an incentive which motivates risky investors to invest in high-risk assets. The extent of the risk premium depends upon the level of risk in a specific security or portfolio, and the rate changes with the market.
A Little More on What is an Equity Risk Premium
The value of risk premium depends on the possibility of the risk reward tradeoff. As a forward-looking amount, the value of the risk premium is hypothetical, as nobody knows how a specific stock will perform later on.
To estimate the value risk premium for a particular security, analysts employ the capital assets pricing model (CAPM), which is generally expressed as:
Ra = Rf + βa (Rm – Rf)
Ra = expected rate of return in “a”
RF = risk free rate of return
βa = beta of “a”
Rm = expected return of market
References for Equity Risk Premium
Academic Research on Equity Risk Premium
● The equity risk premium a solution, Rietz, T. A. (1988). Journal of monetary Economics, 22(1), 117-131. In ‘The Equity Risk Premium: A Puzzle’, Mehra and Prescott (1985) developed an Arrow-Debreau asset pricing model. However, this model has been rejected due to its inability to solve the puzzle of equity risk premium. The author shows that the Arrow-Debreau model can be used successfully in a situation where market crash is optimized.
● Global evidence on the equity risk premium, Dimson, E., Marsh, P., & Staunton, M. (2003). Journal of Applied Corporate Finance, 15(4), 27-38. This paper analyses the importance of the size of the equity risk risk premium in an economy.
● Forecasting the equity risk premium: the role of technical indicators, Neely, C. J., Rapach, D. E., Tu, J., & Zhou, G. (2014). Management Science, 60(7), 1772-1791. This paper aims to show that combining information from both technical indicators and macroeconomic variables significantly improves equity risk premium forecasts versus using either type of information alone. The authors aim to achieve this by comparing the predictive ability of technical indicators with that of macroeconomic variables.
● The levered equity risk premium and credit spreads: A unified framework, Bhamra, H. S., Kuehn, L. A., & Strebulaev, I. A. (2009). The Review of Financial Studies, 23(2), 645-703. In this research, the authors embed a structural model of credit risk inside a dynamic continuous-time consumption-based asset pricing model, which allows them to price equity and corporate debt in a unified framework.
● The equity risk premium: emerging vs. developed markets, Salomons, R., & Grootveld, H. (2003). Emerging markets review, 4(2), 121-144. This article gives an empirical view of the ex post equity risk premium in a number of international markets with special attention to emerging ones as opposed to established markets.
● Stocks versus bonds: explaining the equity risk premium, Asness, C. S. (2000). Financial Analysts Journal, 56(2), 96-113. This paper analyses the dividends and earnings yield on stocks from the 19th century through the mid-20th century, and compares it to the long-term yield of US government bonds during the 20th century.
● Audit firm tenure and the equity risk premium, Boone, J. P., Khurana, I. K., & Raman, K. K. (2008). Journal of Accounting, Auditing & Finance, 23(1), 115-140. This paper explores the role of investor perceptions of audit quality in maintaining systemic confidence in the integrity of financial accounting reports. In this study, investigations are carried out on whether investors price audit firm tenure for Big Five audits by examining the relation between tenure and the ex ante equity risk premium over the risk-free interest rate.
● Estimating the equity risk premium using accounting fundamentals, O’Hanlon, J., & Steele, A. (2000). Journal of Business Finance & Accounting, 27(9‐10), 1051-1083. This study uses recent developments in the theoretical modelling of the links between unrecorded accounting goodwill, accounting profitability and the cost of equity, together with Capital Asset Pricing Model (CAPM) betas, to estimate the ex‐ante equity risk premium in the UK.
● The long-run equity risk premium, Graham, J. R., & Harvey, C. R. (2005). Finance Research Letters, 2(4), 185-194. This paper presents expectations of the equity risk premium measured over a 10-year horizon relative to a 10-year US Treasury bond based on a survey of US Chief Financial Officers (CFOs). Results gotten from a 1995 to 2005 survey suggests that there is a positive correlation between the ex ante risk premium and real interest rates as reflected in Treasury Inflation Indexed Notes.
● Earnings quality and the equity risk premium: A benchmark model, Yee, K. K. (2006). Contemporary Accounting Research, 23(3), 833-877. This paper solves a model that links earnings quality to the equity risk premium in an infinite‐horizon consumption capital asset pricing model (CAPM) economy. The model demonstrates that earnings quality magnifies fundamental risk. The model ties together consumption CAPM and accounting‐based valuation research into one price formula linking earnings quality to the equity risk premium and earnings capitalization factors.
● History and the equity risk premium, Goetzmann, W. N., & Ibbotson, R. G. (2005). Yale School of Management. This paper explores the historical development of the idea of the equity risk premium and its empirical measurement by financial economists. This paper focuses on the theory of compensation for investment risk developed in the 20th century in tandem with the empirical analysis of historical investment performance.
● Perspectives on the equity risk premium, Siegel, J. J. (2005). Financial Analysts Journal, 61(6), 61-73. This paper analyses the undisputable importance of equity premium in financial economics. It explores the need for a simple model to justify the premium in face of the much lower volatility of aggregate economic data. It also analyses the potential reward of the equity risk premium to short term bond investors.