The Equity Risk Premium: A Review of Models

19 Pages Posted: 16 Dec 2016 Last revised: 27 Oct 2017

See all articles by Fernando Duarte

Fernando Duarte

Federal Reserve Bank of New York

Carlo Rosa

Federal Reserve Banks - Federal Reserve Bank of New York

Date Written: 2015

Abstract

The authors estimate the equity risk premium (ERP)—the expected return on stocks in excess of the risk-free rate—by combining information from twenty models for the period 1960-2013. They begin their analysis by categorizing the models into five classes: trailing historical mean, dividend discount, cross-sectional estimation, regression analysis using valuation ratios or macroeconomic variables, and surveys. They find that an optimal weighted average of all models places the one-year-ahead ERP in June 2012 at 12.2 percent, close to levels reached in the mid- and late 1970s, when the ERP was highest in the study sample. The authors note, however, that there is considerable uncertainty in ERP point estimates. The interquartile range across models is 11.6 percent on average, although it reached 6.8 percent in 2012, the lowest level in the study sample. By employing differences across models, the authors argue that the ERP in 2012 is elevated mainly because Treasury yields are low, not because the expected future cash flows from stocks are high.

Keywords: Equity premium, stock returns

JEL Classification: C58, G00, G12, G17

Suggested Citation

Duarte, Fernando and Rosa, Carlo, The Equity Risk Premium: A Review of Models (2015). Economic Policy Review, Issue 2, pp. 39-57, 2015. Available at SSRN: https://ssrn.com/abstract=2886334

Fernando Duarte (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

HOME PAGE: http://www.newyorkfed.org/research/economists/duarte/index.html

Carlo Rosa

Federal Reserve Banks - Federal Reserve Bank of New York ( email )

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