Answer 18

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Read more on estimating risk premiums

See historical risk premiums and implied risk premiums for the US

Implied equity risk premium

The obvious problem is that historical prremiums are backward looking when what you really want is the premium for the future. There are also three measurement problems:
  • Historical risk premiums come with large standard errors. Even with 75 years of data on stock and bond returns, which we can get for the United States, the standard errors remain high (about 2.5%). The problem becomes worse in emerging markets with less data. If you go further back in time (to 1871, for example), you run the risk of getting a risk premium that means very little at the current time.
  • If you decide to use historical data in the United States because you have a long and easily accessible history, you run into a problem of selection bias. After all, the U.S, market was the most successful market of the twentieth century; as a consequence, the premium you get will be too high as a forward-looking estimate. A more reasonable estimate would require you to look across a number of different equity markets over the twentieth century and compute an average premium over the markets.
  • Markets are priced based upon investor assessments of how risky stocks are and how much of a premium they should charge for investing in stocks. In bullish times, stock prices rise as investors become more optimistic about the future and reduce their required risk premiums. As stock prices rise and deliver high positive returns, historical risk premiums go up. In other words, historical risk premiums rise just as investor's expected risk premiums decrease.
There is an alternative to historical premiums. Based upon how stocks are priced collectively (looking at a broad equity index) and the expected cashflows you would get from buying these stocks (dividends, for instance), you can back out the risk premium that investors are demanding. This risk premium is called an implied equity risk premium.The historical risk premium form 1928-2002 in the United States was 4.53%. The implied equity risk premium declined to 2% at the height of the bull market in 1999 and has averaged about 4% over the last 40 years.


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