Equity premium: Historical, expected, required and implied
AbstractEquity premium designates 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 conveyed in the literature regarding 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 all investors, the REP, the EEP and the IEP differ for different investors. A unique IEP requires assuming homogeneous expectations for 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 also investigate 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 single 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.
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Bibliographic InfoPaper provided by IESE Business School in its series IESE Research Papers with number D/661.
Length: 41 pages
Date of creation: 13 Dec 2006
Date of revision:
equity premium; equity premium puzzle; required market risk premium; historical market risk premium; expected market risk premium; risk premium; market risk premium; market premium;
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-02-17 (All new papers)
- NEP-FMK-2007-02-17 (Financial Markets)
- NEP-HIS-2007-02-17 (Business, Economic & Financial History)
- NEP-IFN-2007-02-17 (International Finance)
- NEP-RMG-2007-02-17 (Risk Management)
- NEP-UPT-2007-02-17 (Utility Models & Prospect Theory)
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