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Equity premium: Historical, expected, required and implied

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  • Fernandez, Pablo

    (IESE Business School)

Abstract

Equity premium designates four different concepts: Historical Equity Premium (HEP); Expected Equity Premium (EEP);Required Equity Premium (REP); and Implied Equity Premium (IEP). We highlight the confusing message conveyed in the literature regarding equity premium and its evolution. The confusion arises from not distinguishing among the four concepts and from not recognizing that although the HEP is equal for all investors, the REP, the EEP and the IEP differ for different investors. A unique IEP requires assuming homogeneous expectations for expected growth (g), but we show that there are several pairs (IEP, g) that satisfy current prices. We claim that different investors have different REPs and that it is impossible to determine the REP for the market as a whole, because it does not exist. We also investigate the relationship between (IEP - g) and the risk-free rate. There is a kind of schizophrenic approach to valuation: while all authors admit different expectations of equity cash flows, most authors look for a single discount rate. It seems as if the expectations of equity cash flows are formed in a democratic regime, while the discount rate is determined in a dictatorship.

Suggested Citation

  • Fernandez, Pablo, 2006. "Equity premium: Historical, expected, required and implied," IESE Research Papers D/661, IESE Business School.
    • Handle: RePEc:ebg:iesewp:d-0661
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    File URL: http://www.iese.edu/research/pdfs/DI-0661-E.pdf
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    Cited by:

    1. Alain Abou & Georges Prat, 2009. "The dynamics of U.S. equity risk premia: lessons from professionals'view," Working Papers hal-04140869, HAL.
    2. Fernández, Pablo & Aguirreamalloa, Javier & Corres, Luis, 2013. "Market Risk Premium Used in 82 Countries in 2012: A Survey with 7,192 Answers," IESE Research Papers D/1059, IESE Business School.
    3. Prat, Georges, 2013. "Equity risk premium and time horizon: What do the U.S. secular data say?," Economic Modelling, Elsevier, vol. 34(C), pages 76-88.
    4. David Laidler & William B.P. Robson, 2007. "Ill-Defined Benefits: The Uncertain Present and Brighter Future of Employee Pensions in Canada," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 250, June.
    5. von Borstel, Julia & Eickmeier, Sandra & Krippner, Leo, 2016. "The interest rate pass-through in the euro area during the sovereign debt crisis," Journal of International Money and Finance, Elsevier, vol. 68(C), pages 386-402.
    6. Peter Christoffersen & Kris Jacobs & Chayawat Ornthanalai, 2009. "Exploring Time-Varying Jump Intensities: Evidence from S&P500 Returns and Options," CIRANO Working Papers 2009s-34, CIRANO.
    7. Georges Prat, 2010. "Equity Risk Premium and Time Horizon : What do the U.S. Secular Data Say ?," Working Papers hal-04140905, HAL.
    8. Fernandez, Pablo, 2006. "The equity premium in finance and valuation textbooks," IESE Research Papers D/657, IESE Business School.
    9. Martin Casta, 2021. "Deriving Equity Risk Premium Using Dividend Futures," Working Papers 2021/1, Czech National Bank.
    10. Fernandez, Pablo, 2008. "The equity premium in 100 textbooks," IESE Research Papers D/757, IESE Business School.

    More about this item

    Keywords

    equity premium; equity premium puzzle; required market risk premium; historical market risk premium; expected market risk premium; risk premium; market risk premium; market premium;
    All these keywords.

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