What Are the Determinants of Risk Premiums?
If equity risk premiums and default spreads were constant, estimating them would be much easier. However, both measures change over time. This section considers the determinants of equity risk premiums and then extends the discussion to cover default spreads.
Equity Risk Premiums
The equity risk premium reflects the “extra” return that investors demand for investing in equities (or risky assets) as a class, relative to the risk-free investment. Not surprisingly, it is affected by almost everything that occurs in the overall economy. In particular, we would expect it to be a function of the following:
Risk aversion: The first and most critical factor, obviously, is the risk aversion of investors in ...
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