Equity Risk Premium. An Estimate Inspired on Behavioural Finance

CADERNOS DO MERCADO DE VALORES MOBILIÁRIOS, No. 47

12 Pages Posted: 21 Apr 2019

Date Written: APRIL 2014

Abstract

Although Capital Asset Pricing Model is very convenient for estimating the Cost of Capital for long-term investments, it requires the determination and use of a value for the equity risk premium (ERP). Using Prospect Theory introduced by Kahneman and Tversky and assuming a Brownian motion for any volatile asset, it seems possible to estimate such a premium from two market parameters – volatility and risk-free rate – and from the estimates of two human characteristics – the multiple of the valuation of the pain produced by losses in comparison to the satisfaction extracted from the alternative gains, plus the non-linearity of the risk-aversion/risk-loving curve. Under common values for these parameters, the ERP should be 7% p.a. Therefore, it seems that Mehra and Prescott estimated an insufficient premium, because they considered only that non-linearity, and not the gains-losses asymmetry.

Keywords: CAPM, Equity Premium, Behavioral Finance

JEL Classification: C58, G02, G12, G32

Suggested Citation

Costa, José, Equity Risk Premium. An Estimate Inspired on Behavioural Finance (APRIL 2014). CADERNOS DO MERCADO DE VALORES MOBILIÁRIOS, No. 47, Available at SSRN: https://ssrn.com/abstract=3357417

José Costa (Contact Author)

EURONEXT LISBON ( email )

RUA LUIS MANUEL NORONHA 10
1495-140 ALGÉS
Portugal

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