Changes in the Market Risk Premium and the Cost of Capital: Implications for Practice
14 Pages Posted: 12 Nov 2015
Date Written: November 5, 2015
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.
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