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The Expected Cost of Equity and the Expected Risk Premium in the UK

  • Alan Gregory
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    In this paper, it is argued that previous estimates of the expected cost of equity and the expected arithmetic risk premium in the UK show a degree of upward bias. Given the importance of the risk premium in regulatory cost of capital in the UK, this has important policy implications. There are three reasons why previous estimates could be upward biased. The first two arise from the comparison of estimates of the realised returns on government bond (‘gilt’) with those of the realised and expected returns on equities. These estimates are frequently used to infer a risk premium relative to either the current yield on index-linked gilts or an ‘adjusted’ current yield measure. This is incorrect on two counts; first, inconsistent estimates of the risk-free rate are implied on the right hand side of the capital asset pricing model; second, they compare the realised returns from a bond that carried inflation risk with the realised and expected returns from equities that may be expected to have at least some protection from inflation risk. The third, and most important, source of bias arises from uplifts to expected returns. If markets exhibit ‘excess volatility’, or f part of the historical return arises because of revisions to expected future cash flows, then estimates of variance derived from the historical returns or the price growth must be used with great care when uplifting average expected returns to derive simple discount rates. Adjusting expected returns for the effect of such biases leads to lower expected cost of equity and risk premia than those that are typically quoted.

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    Article provided by Emerald Group Publishing in its journal Review of Behavioral Finance.

    Volume (Year): 3 (2011)
    Issue (Month): 1 (September)
    Pages: 1-26

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    Handle: RePEc:eme:rbfpps:v:3:y:2011:i:1:p:1-26
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    1. Eugene Fama & F. & Kenneth R. French, . "The Equity Premium."," CRSP working papers 522, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    2. Daniel C. Indro & Wayne Y. Lee, 1997. "Biases in Arithmetic and Geometric Averages as Estimates of Long-Run Expected Returns and Risk Premia," Financial Management, Financial Management Association, vol. 26(4), Winter.
    3. Campbell, John, 1996. "Understanding Risk and Return," Scholarly Articles 3153293, Harvard University Department of Economics.
    4. Allan Timmermann & M. Hashem Pesaran, 1999. "A Recursive Modelling Approach to Predicting UK Stock Returns," FMG Discussion Papers dp322, Financial Markets Group.
    5. Ian Cooper, 1996. "Arithmetic versus geometric mean estimators: Setting discount rates for capital budgeting," European Financial Management, European Financial Management Association, vol. 2(2), pages 157-167.
    6. Robert J. Shiller & John Y. Campbell, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Cowles Foundation Discussion Papers 812, Cowles Foundation for Research in Economics, Yale University.
    7. Fama, Eugene F, 1996. "Discounting under Uncertainty," The Journal of Business, University of Chicago Press, vol. 69(4), pages 415-28, October.
    8. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
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