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Equity premium: Historical, expected, required and implied

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  • Fernandez, Pablo

    ()
    (IESE Business School)

Abstract

Equity 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 Info

Paper provided by IESE Business School in its series IESE Research Papers with number D/661.

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Length: 41 pages
Date of creation: 13 Dec 2006
Date of revision:
Handle: RePEc:ebg:iesewp:d-0661

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Postal: IESE Business School, Av Pearson 21, 08034 Barcelona, SPAIN
Web page: http://www.iese.edu/
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Related research

Keywords: equity premium; equity premium puzzle; required market risk premium; historical market risk premium; expected market risk premium; risk premium; market risk premium; market premium;

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Cited by:
  1. Fernandez, Pablo, 2006. "The equity premium in finance and valuation textbooks," IESE Research Papers D/657, IESE Business School.
  2. Prat, Georges, 2013. "Equity risk premium and time horizon: What do the U.S. secular data say?," Economic Modelling, Elsevier, vol. 34(C), pages 76-88.
  3. Peter Christoffersen & Kris Jacobs & Chayawat Ornthanalai, 2009. "Exploring Time-Varying Jump Intensities: Evidence from S&P500 Returns and Options," CIRANO Working Papers 2009s-34, CIRANO.
  4. David Laidler & William B.P. Robson, 2007. "Ill-Defined Benefits: The Uncertain Present and Brighter Future of Employee Pensions in Canada," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 250, June.
  5. Jacob Oded & Allen Michel & Steven P. Feinstein, 2011. "Distortion in corporate valuation: implications of capital structure changes," Managerial Finance, Emerald Group Publishing, vol. 37(8), pages 681-696, August.
  6. Fernandez, Pablo, 2008. "The equity premium in 100 textbooks," IESE Research Papers D/757, IESE Business School.

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