Changes in the Market Risk Premium and the Cost of Capital: Implications for Practice

14 Pages Posted: 12 Nov 2015

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

Felicia C. Marston

University of Virginia - McIntire School of Commerce

Multiple version iconThere are 2 versions of this paper

Date Written: November 5, 2015

Abstract

This paper provides evidence that the equity market risk premium is not constant and draws implications for estimating the cost of capital. Using data from US markets, we demonstrate that the equity market risk premium varies substantially over time. Moreover, these variations are linked to changes in long-term interest rates, credit spreads on corporate bonds and anticipated volatility in equity markets. Given these patterns, the common practice of using a constant market risk premium creates estimates which overstate the response of shareholder return requirements to changes in interest rates and ignore key shifts in risks facing investors. Improved practice would incorporate an estimate of the market risk premium that reflects current market conditions and the relationships among the equity risk premium, interest rates and key metrics of market risk.

Suggested Citation

Harris, Robert S. and Marston, Felicia C., Changes in the Market Risk Premium and the Cost of Capital: Implications for Practice (November 5, 2015). Journal of Applied Finance (Formerly Financial Practice and Education), Vol. 23, No. 1, 2013, Available at SSRN: https://ssrn.com/abstract=2686739

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

Felicia C. Marston

University of Virginia - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States
804-924-1417 (Phone)

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