The equity (or market risk) premium: 150 text books reviewedby Pablo Fernandez
The equity premium (also called market risk premium, equity risk premium, market premium and risk premium), is one of the most important and discussed, but elusive parameters in finance.
I review 150 textbooks on corporate finance and valuation published between 1979 and 2009 by authors such as Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Arzac... and find that their recommendations regarding the equity premium range from 3% to 10%, and that 51 books use different equity premia in various pages.
The 5-year moving average has declined from 8.4% in 1990 to 5.7% in 2008 and 2009.
Some confusion arises from not distinguishing among the four concepts that the phrase equity premium designates: the Historical, the Expected, the Implied and the Required equity premium (incremental return of a diversified portfolio over the risk-free rate required by an investor).
1. Historical equity premium (HEP): historical differential return of the stock market over treasuries.
2. Expected equity premium (EEP): expected differential return of the stock market over treasuries.
3. Required equity premium (REP): incremental return of a diversified portfolio (the market) over the risk-free rate required by an investor. It is used for calculating the required return to equity.
4. Implied equity premium (IEP): the required equity premium that arises from assuming that the market price is correct.
Finance textbooks should clarify the equity premium by incorporating distinguishing definitions of the four different concepts and conveying a clearer message about their sensible magnitudes.
Full paper available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1473225
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Reproduced on www.reportwatch.net by kind permission of the author, and made available thanks to the Social Science Research Network (http://papers.ssrn.com/).
Other papers on valuation by Pablo Fernandez: http://ssrn.com/author=12696
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