The Equity Risk Premium in 2012

Abstract

We analyze the history of the equity risk premium from surveys of U.S. Chief Financial Officers (CFOs) conducted every quarter from June 2000 to March 2012. The risk premium is the expected 10-year S&P 500 return relative to a 10-year U.S. Treasury bond yield. While the risk premium sharply increased during the financial crisis peaking in February 2009, the premium steadily fell until the second quarter 2010. The current surveys show that the premium has increased to near to the levels during the financial crisis. The survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. We find that dispersion of beliefs is above average as well as individual uncertainty. We find little relation between our survey-based risk premium and a measure of the implied cost of capital that relies on individual firms’ forecasted future cash flows. We also present evidence on the determinants of the long-run risk premium. Our analysis suggests the level of the risk premium closely tracks both market volatility (reflected in the VIX index) as well as credit spreads. However, the most recent data show a puzzling divergence between VIX and our measure of the risk premium. Our analysis suggests that market volatility is inexplicably low.

Keywords: Cost of capital, financial crisis, equity premium, long-term market returns, long-term equity returns, expected excess returns, disagreement, individual uncertainty, skewness, asymmetry, survey methods, risk and reward, TIPs, VIX, Credit spreads, Implied cost of capital

JEL Classification: G11, G31, G12, G14