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Equity Risk Premium

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  • Richard Derrig
  • Elisha Orr

Abstract

The equity risk premium (ERP) is an essential building block of the market value of risk. In theory, the collective action of all investors results in an equilibrium expectation for the return on the market portfolio excess of the risk-free return, the ERP. The ability of the valuation actuary to choose a sensible value for the ERP, whether as a required input to capital asset pricing model valuation, or any of its descendants, is as important as choosing risk-free rates and risk relatives (betas) to the ERP for the asset at hand.The historical realized ERP for the stock market appears to be at odds with pricing theory parameters for risk aversion. Since 1985, there has been a constant stream of research, each of which reviews theories of estimating market returns, examines historical data periods, or both. Those ERP value estimates vary widely from about −1% to about 9%, based on a geometric or arithmetic averaging, short or long horizons, short- or long-run expectations, unconditional or conditional distributions, domestic or international data, data periods, and real or nominal returns.This paper examines the principal strains of the recent research on the ERP and catalogues the empirical values of the ERP implied by that research. In addition, the paper supplies several time series analyses of the standard Ibbotson Associates 1926–2002 ERP data using short Treasuries for the risk-free rate. Recommendations for ERP values to use in common actuarial valuation problems also are offered.

Suggested Citation

  • Richard Derrig & Elisha Orr, 2004. "Equity Risk Premium," North American Actuarial Journal, Taylor & Francis Journals, vol. 8(1), pages 45-69.
    • Handle: RePEc:taf:uaajxx:v:8:y:2004:i:1:p:45-69
    DOI: 10.1080/10920277.2004.10596128
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    Citations

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    Cited by:

    1. Kanak Patel & Ricardo Pereira & Kirill Zavodov, 2009. "Mean-Reversion in REITs Discount to NAV & Risk Premium," The Journal of Real Estate Finance and Economics, Springer, vol. 39(3), pages 229-247, October.
    2. Chatzitzisi, Evanthia & Fountas, Stilianos & Panagiotidis, Theodore, 2021. "Another look at calendar anomalies," The Quarterly Review of Economics and Finance, Elsevier, vol. 80(C), pages 823-840.
    3. Peña, Juan Ignacio & Rodríguez, Rosa, 2006. "On the economic link between asset prices and real activity," DEE - Working Papers. Business Economics. WB wb063209, Universidad Carlos III de Madrid. Departamento de Economía de la Empresa.
    4. Barrett, Alan & Kearney, Ide & O'Brien, Martin, 2007. "Quarterly Economic Commentary, Summer 2007," Forecasting Report, Economic and Social Research Institute (ESRI), number QEC20072, June.
    5. Maheu, John M. & McCurdy, Thomas H., 2009. "How Useful are Historical Data for Forecasting the Long-Run Equity Return Distribution?," Journal of Business & Economic Statistics, American Statistical Association, vol. 27, pages 95-112.
    6. Whelan, Shane, 2007. "Valuing Ireland's Pension System," Quarterly Economic Commentary: Special Articles, Economic and Social Research Institute (ESRI), vol. 2007(2-Summer), pages 55-80.
    7. Juan Ignacio Peña & Rosa Rodríguez, 2007. "On the Economic Link Between Asset Prices and Real Activity," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 34(5‐6), pages 889-916, June.

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