The Equity Risk Premium

What is the ERP?

 

The equity risk premium is the extra return that investors demand over and above a risk free rate to invest in equities as a class. Thus, it is a receptacle for investor hopes and fears, with the number rising when the fear quotient dominates the hope quotient. In buoyant times, when investors are not fazed by risk and hope is the dominant force, equity risk premiums can fall. In the graph below, you can see the estimates of the implied equity risk premium for US stocks from 1961 to 2013 (year ends) with annotations providing the rationale for the shifts over time periods. 

 

The average implied equity risk premium over the entire period is 4% and that number is the basis for the bullishness that some investors/analysts bring to the market. If the equity risk premium, currently at 5%, does drop to 4% , the S&P 500 would trade at 2340, an increase of 24.8% on current levels. And history, as Duarte and Rosa note, is on your side, albeit with significant noise, in making this assumption that equity risk premiums revert back to norms over time. As we could argue, the high ERP in 2013 is very different from high ERPs in previous time periods and extrapolating from past history can be dangerous. 

 

 

What Risk Premium is Normal?
FAJ_Mar_Apr_2002_What_Risk_Premium_is_No
Adobe Acrobat Document 597.0 KB
ERP.pdf
Adobe Acrobat Document 410.5 KB
Foundations_of_Factor_Investing.pdf
Adobe Acrobat Document 1.0 MB

Sovereign default probabilities online

Country Risk Premiums

ctryprem_Feb2016_Damodaran.xls
Microsoft Excel Table 686.0 KB

Implied Risk Premium Calculator

implied ERP Calc_Jan16.xls
Microsoft Excel Table 240.5 KB
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