Equity Premium: Historical, Expected, Required and Implied Essay

18398 Words Mar 15th, 2014 74 Pages
Pablo Fernandez IESE Business School, University of Navarra

Ch 12 Equity Premium: Historical, Expected, Required and Implied

Equity Premium: Historical, Expected, Required and Implied
Pablo Fernandez Professor of Finance. IESE Business School, University of Navarra Camino del Cerro del Aguila 3. 28023 Madrid, Spain e-mail: fernandezpa@iese.edu January 29, 2013

The 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 in the literature regarding the equity premium and its evolution. The confusion arises from not distinguishing among the four concepts and from not
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3.4. Other estimates of the expected equity premium

4. Required and implied equity premium 5. The equity premium puzzle 6. The equity premium in the textbooks 7. There is not an IEP, but many pairs (IEP, g) which are consistent with market prices 8. How do I calculate the REP? 9. Conclusion

Ch 12- 1

Electronic copy available at: http://ssrn.com/abstract=933070

Pablo Fernandez IESE Business School, University of Navarra 1.

Ch 12 Equity Premium: Historical, Expected, Required and Implied

Introduction

The equity premium (also called market risk premium, equity risk premium, market premium and risk premium) is one of the most important, but elusive parameters in finance. Some confusion arises from the fact that the term equity premium is used to designate four different concepts: 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 the market portfolio over the risk-free rate required by an investor in order to hold the market portfolio1. It is needed for calculating the required return to equity (cost of equity). The CAPM assumes that REP and EEP are unique and that REP = EEP. 4. Implied Equity Premium (IEP): the required equity premium that arises from a pricing model and from assuming that the market price is correct. The four concepts are

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