Modelling the Equity Risk Premium in the Long Term: A UK and US Update

32 Pages Posted: 9 Aug 2000 Last revised: 13 Jul 2020

See all articles by John Okunev

John Okunev

Bond University Business School

Allan Hodgson

University of Queensland - Business School

Date Written: February 1, 2000

Abstract

In this paper we present a different approach to modelling the dynamic nature of the equity risk premium to those adopted in prior studies. We attempt to model the time variation of the equity risk premium through the use of a discounted dividend approach to model the ex ante risk premium implied from the information contained in the share price. Our approach differs to other studies in that we attempt to model the stochastic nature of the dividends as an Ornstein Uhlenbeck model and based upon these results we derive the appropriate functional form of the share price. From the formulation of the dividend and share price equations we are able to infer the implied risk premium. Our model shows clearly that the ex ante equity risk premium is mean reverting towards a stable long term mean of 4.0 % for the UK and 4.0% for the US for the period 1923-2019. These results are lower compared to the average ex post risk premium where the average realised risk premium for the UK is 6.0 % and 7.2% for the US. Seeing that there is such a large divergence between ex post and ex ante risk premiums we investigate whether the ex post risk premium reverts to the ex ante risk premium by using a naive model and a more general model. Our results suggest that the more general model offers superior explanatory and forecasting power when compared to the naive model and a macro factor model.

Keywords: Risk Premium

JEL Classification: G1

Suggested Citation

Okunev, John and Hodgson, Allan, Modelling the Equity Risk Premium in the Long Term: A UK and US Update (February 1, 2000). Available at SSRN: https://ssrn.com/abstract=222908 or http://dx.doi.org/10.2139/ssrn.222908

John Okunev (Contact Author)

Bond University Business School ( email )

Gold Coast
Australia

Allan Hodgson

University of Queensland - Business School ( email )

Brisbane, Queensland 4072
Australia

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