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Market risk premium: Required, historical and expected

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  • Fernandez, Pablo

    ()
    (IESE Business School)

Abstract

The market risk premium is one of the most important but elusive parameters in finance. It is also called equity premium, market premium and risk premium. The term 'market risk premium' is difficult to understand because it is used to designate three different concepts: 1) Required market risk premium, which is the incremental return of a diversified portfolio (the market) over the risk-free rate (return of treasury bonds) required by an investor. It is needed for calculating the required return to equity (cost of equity). 2) Historical market risk premium, which is the historical differential return of the stock market over treasury bonds. 3) Expected market risk premium, which is the expected differential return of the stock market over treasury bonds. Many authors and finance practitioners assume that the expected market risk premium is equal to the historical market risk premium and to the required market risk premium. The CAPM assumes that the required market risk premium is equal to the expected market risk premium. However, the three concepts are different. The historical market risk premium is equal for all investors, but the required and the expected market risk premium are different for different investors. We also claim that there is no required market risk premium for the market as a whole: different investors use different required market risk premiums.

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Bibliographic Info

Paper provided by IESE Business School in its series IESE Research Papers with number D/574.

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Length: 31 pages
Date of creation: 17 Oct 2004
Date of revision:
Handle: RePEc:ebg:iesewp:d-0574

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Postal: IESE Business School, Av Pearson 21, 08034 Barcelona, SPAIN
Web page: http://www.iese.edu/
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Keywords: required market risk premium; historical market risk premium; expected market risk premium; risk premium; equity premium; market premium;

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  1. Lubos Pástor & Robert F. Stambaugh, . "The Equity Premium and Structural Breaks," Rodney L. White Center for Financial Research Working Papers 21-98, Wharton School Rodney L. White Center for Financial Research.
  2. Merton H. Miller, 2000. "The History Of Finance: An Eyewitness Account," Journal of Applied Corporate Finance, Morgan Stanley, vol. 13(2), pages 8-14.
  3. Scott Mayfield, E., 2004. "Estimating the market risk premium," Journal of Financial Economics, Elsevier, vol. 73(3), pages 465-496, September.
  4. Philippe Jorion & William N. Goetzmann, 1999. "Global Stock Markets in the Twentieth Century," Journal of Finance, American Finance Association, vol. 54(3), pages 953-980, 06.
  5. Haitao Li & Yuewu Xu, 2002. "Survival Bias and the Equity Premium Puzzle," Journal of Finance, American Finance Association, vol. 57(5), pages 1981-1995, October.
  6. Roger G. Ibbotson & Peng Chen, 2003. "Long-Run Stock Returns: Participating in the Real Economy," Yale School of Management Working Papers ysm354, Yale School of Management.
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