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The equity risk premium: a review of models

Author

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  • Duarte, Fernando M.

    (Federal Reserve Bank of New York)

  • Rosa, Carlo

    (Federal Reserve Bank of New York)

Abstract

The authors estimate the equity risk premium (ERP)—the expected return on stocks in excess of the risk-free rate—by combining information from twenty models for the period 1960-2013. They begin their analysis by categorizing the models into five classes: trailing historical mean, dividend discount, cross-sectional estimation, regression analysis using valuation ratios or macroeconomic variables, and surveys. They find that an optimal weighted average of all models places the one-year-ahead ERP in June 2012 at 12.2 percent, close to levels reached in the mid- and late 1970s, when the ERP was highest in the study sample. The authors note, however, that there is considerable uncertainty in ERP point estimates. The interquartile range across models is 11.6 percent on average, although it reached 6.8 percent in 2012, the lowest level in the study sample. By employing differences across models, the authors argue that the ERP in 2012 is elevated mainly because Treasury yields are low, not because the expected future cash flows from stocks are high.

Suggested Citation

  • Duarte, Fernando M. & Rosa, Carlo, 2015. "The equity risk premium: a review of models," Economic Policy Review, Federal Reserve Bank of New York, issue 2, pages 39-57.
  • Handle: RePEc:fip:fednep:00027
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    References listed on IDEAS

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    Cited by:

    1. Caballero, Ricardo & Farhi, Emmanuel & Gourinchas, Pierre-Olivier, 2017. "Rents, Technical Change, and Risk Premia: Accounting for Secular Trends in Interest Rates, Returns to Capital, Earnings Yields, and Factor Shares," CEPR Discussion Papers 11833, C.E.P.R. Discussion Papers.
    2. Ricardo J. Caballero & Emmanuel Farhi & Pierre-Olivier Gourinchas, 2017. "Rents, Technical Change, and Risk Premia Accounting for Secular Trends in Interest Rates, Returns on Capital, Earning Yields, and Factor Shares," American Economic Review, American Economic Association, vol. 107(5), pages 614-620, May.
    3. Gonçalo Faria & Fabio Verona, 2016. "Forecasting the equity risk premium with frequency-decomposed predictors," Working Papers de Economia (Economics Working Papers) 06, Católica Porto Business School, Universidade Católica Portuguesa.
    4. Paweł Sakowski & Robert Ślepaczuk & Mateusz Wywiał, 2016. "Applying exogenous variables and regime switching to multi-factor models on equity indices," Ekonomia journal, Faculty of Economic Sciences, University of Warsaw, vol. 47.
    5. repec:aea:jecper:v:31:y:2017:i:3:p:29-46 is not listed on IDEAS
    6. Grout, Paul A. & Zalewska, Anna, 2016. "Stock market risk in the financial crisis," International Review of Financial Analysis, Elsevier, vol. 46(C), pages 326-345.
    7. Leiss, Matthias & Nax, Heinrich H. & Sornette, Didier, 2015. "Super-exponential growth expectations and the global financial crisis," LSE Research Online Documents on Economics 65434, London School of Economics and Political Science, LSE Library.
    8. Paweł Sakowski & Robert Ślepaczuk & Mateusz Wywiał, 2016. "Applying Exogenous Variables and Regime Switching To Multifactor Models on Equity Indices," Working Papers 2016-10, Faculty of Economic Sciences, University of Warsaw.
    9. German Gutierrez, 2018. "Investigating Global Labor and Pro t Shares," 2018 Meeting Papers 165, Society for Economic Dynamics.
    10. Williams, John C., 2017. "Three Questions on R-star," FRBSF Economic Letter, Federal Reserve Bank of San Francisco.
    11. repec:eee:ecmode:v:66:y:2017:i:c:p:244-257 is not listed on IDEAS
    12. Andrea Pescatori & Jarkko Turunen, 2015. "Lower for Longer; Neutral Rates in the United States," IMF Working Papers 15/135, International Monetary Fund.
    13. Loukas Karabarbounis & Brent Neiman, 2018. "Accounting for Factorless Income," NBER Chapters,in: NBER Macroeconomics Annual 2018, volume 33 National Bureau of Economic Research, Inc.
    14. Keshav Dogra & Sushant Acharya, 2017. "The Side Effects of Safe Asset Creation," 2017 Meeting Papers 1453, Society for Economic Dynamics.
    15. Pawe³ Sakowski & Robert Œlepaczuk & Mateusz Wywia³, 2016. "Cross-Sectional Returns With Volatility Regimes From A Diverse Portfolio Of Emerging And Developed Equity Indices," "e-Finanse", University of Information Technology and Management, Institute of Financial Research and Analysis, vol. 12(2), pages 23-35, October.
    16. Paweł Sakowski & Robert Ślepaczuk & Mateusz Wywiał, 2015. "Cross-Sectional Returns With Volatility Regimes From Diverse Portfolio of Emerging and Developed Equity Indices," Working Papers 2015-39, Faculty of Economic Sciences, University of Warsaw.
    17. Kovner, Anna & Van Tassel, Peter, 2018. "Regulatory changes and the cost of capital for banks," Staff Reports 854, Federal Reserve Bank of New York, revised 01 Oct 2018.
    18. Andrea Pescatori & Jarkko Turunen, 2016. "Lower for Longer: Neutral Rate in the U.S," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 708-731, November.

    More about this item

    Keywords

    Equity premium; stock returns;

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G00 - Financial Economics - - General - - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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