Estimating Equity Risk Premiums

Abstract

Equity risk premiums are a central component of every risk and return model in finance. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. The standard approach to estimating equity risk premiums remains the use of historical returns, with the difference in annual returns on stocks and bonds over a long time period comprising the expected risk premium, looking forward. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to limited and noisy. We suggest ways in which equity risk premiums can be estimated for these markets, using a base equity premium and a country risk premium. Finally, we suggest an alternative approach to estimating equity risk premiums that requires no historical data and provides updated estimates for most markets.