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Estimating the Equity Premium

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  • John Y. Campbell

Abstract

To estimate the equity premium, it is helpful to use finance theory: not the old-fashioned theory that efficient markets imply a constant equity premium, but theory that restricts the time-series behavior of valuation ratios, and that links the cross-section of stock prices to the level of the equity premium. Under plausible conditions, valuation ratios such as the dividend-price ratio should not have trends or explosive behavior. This fact can be used to strengthen the evidence for predictability in stock returns. Steady-state valuation models are also useful predictors of stock returns given the high degree of persistence in valuation ratios and the difficulty of estimating free parameters in regression models for stock returns. A steady-state approach suggests that the world geometric average equity premium was almost 4% at the end of March 2007, implying a world arithmetic average equity premium somewhat above 5%. Both valuation ratios and the cross-section of stock prices imply that the equity premium fell considerably in the late 20th Century, but has risen modestly in the early years of the 21st Century.

Suggested Citation

  • John Y. Campbell, 2007. "Estimating the Equity Premium," NBER Working Papers 13423, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:13423
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    Cited by:

    1. Ferreira, Miguel A. & Santa-Clara, Pedro, 2011. "Forecasting stock market returns: The sum of the parts is more than the whole," Journal of Financial Economics, Elsevier, vol. 100(3), pages 514-537, June.
    2. repec:dau:papers:123456789/11382 is not listed on IDEAS
    3. Bätje, Fabian & Menkhoff, Lukas, 2016. "Predicting the equity premium via its components," Annual Conference 2016 (Augsburg): Demographic Change 145789, Verein für Socialpolitik / German Economic Association.
    4. Marcelo Bianconi & Joe Akira Yoshino, 2015. "Empirical Estimation of the Cost of Equity: An Application to Selected Brazilian Utilities Companies," Review of Economics & Finance, Better Advances Press, Canada, vol. 5, pages 1-21, February.
    5. Wachter, Jessica A. & Warusawitharana, Missaka, 2015. "What is the chance that the equity premium varies over time? Evidence from regressions on the dividend-price ratio," Journal of Econometrics, Elsevier, vol. 186(1), pages 74-93.
    6. Nieto, Belén & Rubio, Gonzalo, 2011. "The volatility of consumption-based stochastic discount factors and economic cycles," Journal of Banking & Finance, Elsevier, vol. 35(9), pages 2197-2216, September.
    7. Francesco Menoncin & Paolo Panteghini, 2009. "Retrospective Capital Gains Taxation in the Real World," CESifo Working Paper Series 2674, CESifo Group Munich.
    8. Kevin Daly, 2016. "A Secular Increase in the Equity Risk Premium," International Finance, Wiley Blackwell, vol. 19(2), pages 179-200, June.
    9. Dangl, Thomas & Halling, Michael, 2012. "Predictive regressions with time-varying coefficients," Journal of Financial Economics, Elsevier, vol. 106(1), pages 157-181.
    10. Yannick Le Pen & Benoît Sévi, 2013. "Futures trading and the excess comovement of commodity prices," Post-Print hal-01613916, HAL.
    11. Angelidis, Timotheos & Tessaromatis, Nikolaos, 2010. "The efficiency of Greek public pension fund portfolios," Journal of Banking & Finance, Elsevier, vol. 34(9), pages 2158-2167, September.
    12. repec:ipg:wpaper:2013-019 is not listed on IDEAS
    13. Paulo M.M. Rodrigues & Antonio Rubia, 2011. "A Class of Robust Tests in Augmented Predictive Regressions," Working Papers w201126, Banco de Portugal, Economics and Research Department.
    14. repec:ipg:wpaper:19 is not listed on IDEAS
    15. Walentin Karl, 2010. "Earnings Inequality and the Equity Premium," The B.E. Journal of Macroeconomics, De Gruyter, vol. 10(1), pages 1-23, November.

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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