CHAPTER 8
Equity Risk Premium1
Defining the Equity Risk Premium
ERP Is Measured Relative to a Risk-free Rate
Measuring the Average Period of the Expected Cash Flows
Selecting a Sample Period of ex post Data
Bias in Realized Risk Premium Data
Has the Relationship between Stock and Bond Risk Changed?
Comparing Investor Expectations to Realized Risk Premiums
Causes of Unexpectedly Large Realized Risk Premiums
Forward-looking (ex ante) Approaches
INTRODUCTION
The equity risk premium (ERP) (often interchangeably referred to as the market risk premium) is defined as the extra return (over the expected yield on risk-free securities) that investors expect to receive from an investment in the market portfolio of common stocks, represented by a broad-based market index (e.g., S&P 500 Index or the NYSE Index).
As Arnott comments:
For the capital markets to “work,” stocks should produce higher returns than bonds. Otherwise, stockholders would not be paid for the additional risk they take for being lower down in the capital structure. This relationship should be particularly true when stocks are compared to government bonds that (ostensibly) cannot default.2
In a recent paper, the authors ...
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